vvEPA
   KPV*
            United States
            Environmental Protection
            Agency
            Office Of Water
            (4303)
EPA821-R-95-018
February 1995
Economic Impact And Regulatory
Flexibility Analysis Of Proposed
Effluent Guidelines For The
Pharmaceutical Manufacturing
Industry
            $
                      QUANTITY

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Economic Impact and Regulatory Flexibility Analysis
          of Proposed Effluent Guidelines
   for the Pharmaceutical Manufacturing Industry
                    Final Report
          Engineering and Analysis Division
           Office of Science and Technology
                   Office of Water
        U.S. Environmental Protection Agency
                Washington, DC 20460
                 Recycled/Recyclable
                 Printed vwthSoy/Canola Ink on paper that
                 contains at least 50% recycled fiber
                    February 1995

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                                    CONTENTS
FOREWORD

SECTION ONE       EXECUTIVE SUMMARY  	  1-1

      1.1     Overview 	  1-1

      1.2     Data Sources  	  1-1

      1.3     Profile of the Pharmaceutical Industry	  1-2

             1.3.1 Overview of the Pharmaceuticals Industry	  1-2
             1.32 Facility, Owner Company, and Parent Company
                  Characteristics	  1-3
             1.3.3 Industry Structure and the Pharmaceutical Market  	  1-4

      1.4     Overview of the EIA Methodology and Compliance
             Cost Analysis  	  1-5

      1.5     Facility-Level Analysis 	  1-11

      1.6     Firm-Level Analysis  	  1-12

      1.7     Employment and Community-Level Analysis  	  1-19

      1.8     Foreign Trade Impacts	  1-22

      1.9     Regulatory Flexibility Analysis  	  1-22

             1.9.1 Financial Profile of Small Firms  	  1-23
             1.92 Impacts on Small Firms	  1-23

      1.10    Projected Distributional Impacts  	  1-24

      1.11    Impacts on New Sources	  1-27


SECTION TWO       DATA SOURCES	  2-1

      2.1     The Section 308 Pharmaceutical Survey	  2-1

      2.2     U.S. Department of Commerce Data	  2-3

      2.3     References	  2-5

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                                 CONTENTS (cont)
SECTION THREE     PROFILE OF THE PHARMACEUTICAL INDUSTRY	 3-1

      3.1     Overview of Pharmaceutical Products, Regulations,
             and Manufacturing Processes	 3-1

             3.1.1 Pharmaceutical Products and Regulations	 3-2
             3.12 Manufacturing Processes	  3-11

      3.2     Facility, Owner Company, and Parent Company Characteristics	  3-14

             3.2.1 Number of Establishments and Employees 	  3-15
             3.2.2 Value of Shipments	  3-18
             3.2.3 Production Costs	  3-26
             3.2.4 International Trade	  3-31
             3.2.5 Financial Conditions	  3-34

      3.3     Industry Structure and the Pharmaceutical Market	  3-44

             3.3.1 Market Structure	  3-45
             3.32 The Characteristics of Demand for Pharmaceuticals	  3-52
             3.33 Market Conduct and Performance	  3-62
             3.3.4 Conclusions about EIA Assumptions on Cost Passthrough
                 Potential  	  3-68

      3.4     References	  3-68
SECTION FOUR      ECONOMIC IMPACT ANALYSIS METHODOLOGY
                     OVERVIEW AND COMPLIANCE COST ANALYSIS 	 4-1

      4.1     Cost Annualization Model 	 4-3

             4.1.1 Purpose of Cost Annualization 	 4-3
             4.12 Inputs and Assumptions  	 4-4

      4.2     Total Annualized Compliance Costs	  4-14

      4.3     References	  4-17
                                         n

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                                  CONTENTS (cent)
SECTION FIVE       ANALYSIS OF FACILITY-LEVEL IMPACTS	 5-1

      5.1     Facility Closure Model	 5-2

             5.1.1 Salvage Value 	 5-4
             5.12 Present Value of Forecasted Earnings	  5-10
             5.13 Evaluating Closures	  5-15
             5.1.4 Sample Closure Analysis	  5-16

      5.2     Results   	  5-16

             5.2.1 Baseline Closures  	  5-16
             5.22 Postcompliance  Closures	  5-16

      5.3     References	  5-22


SECTION SIX        ANALYSIS OF FIRM-LEVEL IMPACTS	 6-1

      6.1     Ratio Analysis Methodology	 6-2

             6.1.1 Explanation of Ratios  	 6-3
             6.1.2 Recalculating Ratios Incorporating Compliance Costs	 6-5
             6.13 Evaluating Baseline and Postcompliance Ratios  	 6-6

      6.2     Results   	  6-10

             6.2.1 Baseline and Postcompliance Analysis 1—Standard
                  Methodology	  6-11
             6.22 Postcompliance Analysis 2	  6-17
             6.23 Postcompliance Analysis 3	  6-20
             6.2.4 Further Investigation into Likelihood of Firms
                  Failing in the Baseline	  6-20
             6.2.5 Profitability Analysis  	  6-24

      63     References	  6-26
SECTION SEVEN     EMPLOYMENT AND COMMUNITY-LEVEL IMPACTS  	  7-1

      7.1     Primary and Secondary Employment Losses	  7-2

             7.1.1 Introduction  	  7-2
             7.12 Methodology	  7-2

                                         iii

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                                 CONTENTS (coat.)
             7.13  Results  	  7-6

      7.2     Labor Requirements and Potential Employment Benefits  	  7-15

             7.2.1  Introduction  	  7-15
             7.2.2  Estimating Direct Labor Requirements	  7-16
             7.23  Estimating the Secondary (Indirect and Induced)
                  Labor Requirement Effects	  7-21

      7.3     Net Effect of Employment Losses and Gains	  7-24

      7.4     References	  7-25


SECTION EIGHT     ANALYSIS OF FOREIGN TRADE IMPACTS	  8-1

      8.1     Methodology  	  8-1

      8.2     Results   	  8-2


SECTION NINE       REGULATORY FLEXIBILITY ANALYSIS 	  9-1

      9.1     Introduction	  9-1

      9.2     Summary of EPA Guidelines on RFA Requirements	  9-1

      9.3     IRFA Information Requirements	  9-3

             93.1  Reasons  for Taking Action and Objectives of and Legal
                  Basis for the Proposed Rule 	  9-3
             93.2  Estimates of the Affected Population of Small Businesses	  9-3
             9.33  Projected Recordkeeping and Reporting Requirements	  9-4
             9.3.4  Other Federal Requirements	  9-7
             9.3.5  Significant Alternatives to the Proposed Rule	  9-7

      9.4     Profile of Small Pharmaceutical Firms	  9-8

      9.5     Impacts on Small Pharmaceutical Firms	  9-12

             9.5.1  Firm Failure Analysis  	  9-12
             9.5.2  Discounted Net Income Analysis	  9-14

      9.6     References	  9-17

                                         iv

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                            CONTENTS (cent)
SECTION TEN      ANALYSIS OF DISTRIBUTIONAL IMPACTS  	  10-1

     10.1    Increases in Drug Prices	  10-2

     10.2    Impacts on Specific Demographic Groups 	  10-4

     10.3    References	  10-6


SECTION ELEVEN   ANALYSIS OF IMPACTS ON NEW SOURCES 	  11-1


APPENDIX A       ASSUMPTIONS USED OR CONSIDERED FOR USE
                 IN THE COST ANNUALIZATION MODEL	A-l

APPENDIX B       RESULTS OF SENSITIVITY ANALYSIS USING NO
                 SALVAGE VALUE IN COMPUTING FACILITY CLOSURES . B-l

APPENDIX C       ANALYSIS OF THE ALTERNATIVE REGULATORY	C-l
                 SCENARIO

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                                       TABLES
 able
1-1     Regulatory Options Considered in the Economic Impact Analysis  	1-6
1-2     Compliance Costs for Selected Regulatory Options  	1-10
1-3     Facility Closures for Selected Options: Postcompliance Analysis  	1-13
1-4     Postcompliance Analysis 1  	1-15
1-5     Postcompliance Analysis 2  	1-16
1-6     Postcompliance Analysis 3  	1-18
1-7     Percentage Decline in ROA, by Type of Facility	1-20
1-8     Compliance Costs as a Percentage of Total Costs, by Facility	1-25

3-1     Number of Pharmaceutical Establishments by Employee Size	3-16
3-2     Total Number of Employees and Production Workers  	3-17
3-3     Surveyed Facilities by Number of Employees 	3-19
3-4     Value of Shipments  	3-20
3-5     Value of Shipments by Employee Size of Establishment	3-22
3-6     Value of Product Shipments by Prescription/Nonprescription	3-23
3-7     Facility, Owner Company, and Parent Company Revenues	3-24
3-8     Distribution of Surveyed Facilities by Value of Shipments  	3-25
3-9     Number of Surveyed Owner Companies and Parent Companies by
        Total Revenues	3-27
3-10    Cost of Pharmaceutical Production in Surveyed Population  	3-29
3-11    Number of Facilities by Percentage of Pharmaceutical Shipments
        Exported	3-35
3-12    Baseline Return on Assets (ROA) and Interest Coverage (ICR)
        Ratios, by Annual Revenues	3-38
3-13    Comparison of Sample Ratios with Published Industry Averages  	3-39
3-14    Summary of Pharmaceutical Industry Profits Study	3-43
3-15    4-, 8-, 20-, and 50-Firm Concentration Ratios	3-48
3-16    Concentration Ratios in the U.S. Prescription Drug Industry,
        by Therapeutic Market	3-50
3-17    Estimates of the Price Elasticity of Demand for Prescription Drugs	3-60
3-18    Change in Producer Price Index for Pharmaceuticals  	3-63
3-19    Change in Consumer Price Index for Pharmaceuticals and Selected
        Health Care Services  	3-65

4-1     Regulatory Options Considered in the Economic Impact Analysis  	4-6
4-2     Sample Spreadsheet for Annualizing Costs	4-11
4-3     Present Value Equations Used in the Cost Annualization Model	4-15
4-4     Compliance Costs for A/C Direct Dischargers  	4-16
4-5     Compliance Costs for B/D Direct Dischargers  	4-18
4-6     Compliance Costs for Indirect Dischargers	4-19
4-7     Compliance Costs for Selected Regulatory Options  	4-20
                                           VI

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Table                                                                              Page

5-1      Assessed Value by Employment Size and Process Categories	5-7
5-2      Current Assets and Assessed Value  	5-9
5-3      Change in Net Income by Employment Size Category 	5-13
5-4      Facility Closures: Baseline Analysis	5-18
5-5      Facility Closures for A/C Direct Dischargers: Postcompliance
         Analysis  	5-19
5-6      Facility Closures for B/D Direct Dischargers: Postcompliance
         Analysis  	5-20
5-7      Facility Closures for Indirect Dischargers: Postcompliance Analysis  	5-21
5-8      Facility Closures for Selected Options: Postcompliance Analysis	5-23

6-1      Baseline Analysis 1	6-12
6-2      Postcompliance Analysis 1 A/C Direct Discharge Regulatory Options 	6-13
6-3      Postcompliance Analysis 1 B/D Direct Discharge Regulatory Options 	6-14
6-4      Postcompliance Analysis 1 PSES Indirect Discharge Regulatory Options	6-15
6-5      Postcompliance Analysis 1 Selected Regulatory Options	6-16
6-6      Postcompliance Analysis 2: Percent Change in ICR Among Firms that Fail
         in the Baseline Analysis  	6-18
6-7      Postcompliance Analysis 2: Percent Change in ROA Among Firms that Fail
         in the Baseline Analysis  	6-19
6-8      Postcompliance Analysis 3: Percent Change in EBIT Among Firms that Fail
         in the Baseline Analysis  	6-21
6-9      Postcompliance Analysis 3: Percent Change in Net Income (NI) Among Firms
         that Fail in the Baseline Analysis	6-22
6-10     Additional Measures of Financial Viability Among Firms that Fail
         in the Baseline Analysis  	6-23
6-11     Profitability Analysis—Percentage Decline in ROA, by Type of
         Facility Owned Among Firms That Fail in the Baseline Analysis  	6-25

7-1      Closures and Primary Employment Losses: Baseline Facility
         and Firm Analysis	7-7
7-2      Primary Employment  Losses: Baseline Analysis	7-9
7-3      Closures and Primary Employment Losses for A/C Direct Discharge
         Options: Postcompliance Facility and Firm Analysis  	7-10
7-4      Closures and Primary Employment Losses for B/D Direct Discharge
         Options: Postcompliance Facility and Firm Analysis  	7-11
7-5      Closures and Primary Employment Losses for Indirect Discharge
         Options: Postcompliance Facility and Firm Analysis  	7-12
7-6      Closures and Primary Employment Losses for Selected Options:
         Postcompliance Facility and Firm Analysis	7-14
7-7      Analysis of Possible Employment Generation Effects of an
         Effluent Guideline for the Pharmaceutical Manufacturing Industry  	7-22

8-1      Loss in Foreign Shipments for Selected Options:  Postcompliance
         Analysis 	8-3
                                          Vll

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Table                                                                              Page

9-1      Size Distribution of Firms in the Section 308 Pharmaceutical Survey	9-5
9-2      Incremental Recordkeeping and Reporting Costs	9-6
9-3      Profile of Pharmaceutical Firms by Size:  Financial Indicators	9-9
9-4      Profile of Pharmaceutical Firms by Size:  Pharmaceutical Costs
         and Revenues	9-10
9-5      Profile of Pharmaceutical Firms by Size:  Shipments and Exports	9-11
9-6      Baseline Firm Failures by Size of Firm	9-13
9-7      Profitability Analysis—Percentage Decline in ROA, by Employment
         Size of Facility  	9-15
9-8      Present Value of Compliance Costs as a Percentage  of Present Value
         of Postcompliance Net Income	9-16

10-1     Compliance Costs  as a Percentage of Total Pharmaceutical Production
         Costs, by Facility	10-3
10-2     Disproportionate Users of Potentially Highly Affected Products	10-5

11-1     Estimated Cost Differential Between Requirements for Existing  and
         New Sources	11-2

A-l      Comparison of Straight Line Depreciation vs. Modified Accelerated
         Cost Recovery System (MACRS)  	  A-4
A-2      Sample Spreadsheet for Annualizing Costs with Interest Payments	  A-5
A-3      Calculation of MACRS Depreciation Rates 	  A-7
A-4      State Corporate Income Taxes  	  A-8
A-5      Sample Spreadsheet for Annualizing Costs Using the IRS
         Section 169 Provision  	A-10

B-l      Salvage Value = 0; Facility Closures: Baseline Analysis	B-4
B-2      Salvage Value = 0; Facility Closures  for A/C Direct Dischargers:
         Postcompliance Analysis	B-5
B-3      Salvage Value = 0; Facility Closures  for B/D Direct Dischargers:
         Postcompliance Analysis	B-6
B-4      Salvage Value = 0; Facility Closures  for Indirect Dischargers:
         Postcompliance Analysis	B-7
B-5      Salvage Value = 0; Facility Closures  for Selected Options:
         Postcompliance Analysis	B-8

C-l      Facility Closures for Alternative Options: Postcompliance
         Analysis  	C-4
C-2      Postcompliance Analysis  1  Alternative Regulatory Options  	C-5
C-3      Closures and Primary Employment Losses for Alternative Options:
         Postcompliance Facility and Firm Analysis	C-6
C-4      Analysis of Possible Employment Generation Effects of an
         Effluent Guideline for the  Pharmaceutical Manufacturing
         Industry Alternative Options	C-7
                                           vm

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Table                                                                              Page

C-5     Incremental Recordkeeping and Reporting Costs for
        Alternative Options  	C-8
C-6     Profitability Analysis for Alternative Options - Percentage
        Decline in ROA, by Employment Size of Facility	C-9
C-7     Present Value of Compliance Costs as a Percentage of Present
        Value of Postcompliance Net Income for Alternative Options 	C-10
C-8     Compliance Costs as a Percentage of Total Pharmaceutical
        Production Costs for Alternative Options, by Facility	C-ll
                                           IX

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                                    SECTION ONE
                              EXECUTIVE SUMMARY
       This economic impact analysis (EIA) examines compliance costs and economic impacts
resulting from the U.S. Environmental Protection Agency's (EPA's) proposed revisions to
effluent guidelines for the U.S. pharmaceutical industry.  The EIA estimates the economic effects
of compliance with the proposed regulation in terms of annualized  costs; facility closures;
changes in rate of return on assets and the interest coverage ratio at the firm level; and
profitability effects at the firm level. In addition, impacts on employment and affected
communities, foreign trade, specific demographic groups, and new sources also are considered.
Finally, a Regulatory Flexibility Analysis detailing the impacts on small businesses within the
pharmaceutical industry is included in the EIA.
1.1    OVERVIEW

       The remainder of this section follows the general outline of the EIA. Section 1.2
summarizes the primary data sources used for the EIA and Section 1.3 profiles the
pharmaceutical industry. Section 1.4 presents an overview of the methodology used in the EIA,
focusing on the cost annualization model.  Section 1.5 presents the facility-level analysis, which
focuses on facility closures, and Section 1.6 investigates firm-level  impacts. Sections 1.7 and 1.8
analyze employment and community-level and foreign trade impacts, respectively. Section 1.9
presents the regulatory flexibility analysis and Section 1.10 investigates distributional impacts
associated with the regulation. Finally, Section 1.11 explores impacts on new sources.
1.2    DATA SOURCES

       Data sources are discussed in detail in Section Two of this EIA. The primary data source
used in the EIA was the Pharmaceutical Survey, which was conducted under the authority of
                                          1-1

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Section 308 of the Clean Water Act. Through the survey, EPA obtained detailed technical and
financial information from a sample of pharmaceutical establishments that potentially would be
affected by EPA's proposed effluent guidelines. The industry was stratified into the following
five groups, based on type of operations conducted:  A) fermentation, B) biological and natural
extraction, C) chemical synthesis, D) formulation and mixing/compounding, and E) research.
EPA censused the facilities in most of these categories, for a total of 202 facilities. EPA sampled
42 facilities in the following categories:  stand-alone facilities in group D that use solvents and
discharge indirectly and Group D facilities with onsite research facilities (i.e., group D/E) that
use solvents and discharge indirectly.

       Another major data source used to supplement the survey data in the EIA is data from
the U.S. Department of Commerce.  Commerce collects a wide range of data, such as number of
establishments, number of employees, volume of shipments, exports, imports, value added,
apparent consumption, and manufacturing costs. Other data sources used include the U.S. Food
and Drug Administration (FDA), Bureau of Labor Statistics (BLS), Dun & Bradstreet (D&B),
Robert Morris Associates (RMA), the Pharmaceutical Manufacturers Association (PMA), and
various journal articles.
1.3    PROFILE OF THE PHARMACEUTICAL INDUSTRY

       1.3.1 Overview of the Pharmaceuticals Industry

       More than 110,000 pharmaceutical products currently are on the market. These products
can be divided into three categories: new drugs (patented, branded drugs); generic drugs
(equivalent versions of previously patented drugs),  and over-the-counter (OTC) drugs (available
without prescription). Drugs are manufactured using an array of complex batch-type processes
and technologies that occur in three main stages:  research and development (R&D);
fermentation, extraction, and chemical synthesis,  which covers the conversion of organic and
chemical substances into bulk active ingredients;  and formulation, which refers to the combining
of bulk active ingredients with other substances to produce proper dosages.
                                           1-2

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       132  Facility, Owner Company, and Parent Company Characteristics

       According to U.S. Department of Commerce data, 1,343 facilities involved in
pharmaceutical production existed in 1990.  These facilities employed 183,000 people. Smaller
facilities (Le., those with less than 100 employees) dominate the pharmaceutical industry,
although a higher percentage of facilities in the pharmaceutical industry have more than 250
employees than in the manufacturing sector overall.  EPA estimates that approximately 286 of
the 1,343 pharmaceutical facilities are either direct or indirect effluent dischargers and might be
affected by the revised effluent regulations.  The Section 308 Survey obtained data from 244 of
these establishments.

       U.S. Department of Commerce data indicate that the value of shipments for the drug
industry were $64.1 billion in 1992. In real terms, growth has averaged 2 to 4 percent annually
for the pharmaceutical industry. The Section 308 Survey data indicate that pharmaceutical
facility revenues average approximately $100 million per facility per year, while average revenues
for owner companies are approximately $600 million. The U.S. pharmaceutical industry also has
consistently maintained a positive balance of trade, with a trade surplus of $961 million in 1991.
According  to the Section 308 Survey, the mean pharmaceutical  export rate for sample facilities
was 8.8 percent in  1990.

       Manufacturing costs for the pharmaceutical industry from 1988 to 1990 rose from $7.4
billion to $9.6 billion at the facility level, from $58.7 billion to $63.8 billion at the owner-company
level, and from $149.1 billion to $177.3 billion at the parent company level. In addition, the
research and development expenditures for the Pharmaceuticals industry are more than 16
percent of sales, one of the highest proportions for any U.S. industry, while promotional
expenditures account for approximately 22 percent of the industry's revenues.

       Data from the Section 308 Survey indicate that the median rate of return on assets at the
facility level from 1988 to 1990 ranged from approximately -3 percent  to 10 percent.  The interest
coverage ratios vary from approximately -1 percent to 51,267 percent.  In addition, the
profitability of the  pharmaceutical industry appears to be above average among U.S. industries.
                                           1-3

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       1.3.3  Industry Structure and the Pharmaceutical Market

       Although the number of pharmaceutical facilities has grown over the past several
decades, it is likely that competition would have been greater in the industry if high R&D costs,
FDA regulations, and other factors did not serve as barriers to entry into the industry.  In
addition, concentration ratios in the pharmaceutical industry, as well as exit and entry into the
industry, are quite high. There  also is some indication that pharmaceutical companies are
vertically integrated as  discussed further in Section Three. These factors all affect entry of new
firms into  the pharmaceutical market.

       Demand conditions vary significantly among specific  drug markets. In the prescription
drug market, demand is complicated by the role of health care providers and the presence of
health insurance, which reduce the competitive nature of the market.  The lack of price
sensitivity  among consumers, however, is partly offset by increasing sensitivity among insurers.
Demand for OTC drugs, on the other hand, conforms more  readily to standard models of
consumer  demand.

       The degree of substitutability among Pharmaceuticals varies.  Patented drugs in the
United States enjoy ostensible protection from bioequivalent drugs for a number of years, which
limits direct substitutability.  The increase in generic drugs, however, increases substitutability
once the patent for a drug expires. For OTC drugs, the market is much like other competitive
commodity markets, with a high degree of substitutability causing demand to be relatively
sensitive to price changes. In addition, Pharmaceuticals are  not a very close substitute for most
other forms of medical treatments, although they might act as complements.

       These factors seem to lead to price inelasticity for Pharmaceuticals as a whole.  Available
studies indicate that the demand for Pharmaceuticals  as a group may be quite inelastic (i.e.,
between 0 and -1.0).  Demand for specific drug products, however, may be relatively elastic (i.e.,
less than -1.0).  The absence of close substitutes for drug therapies in general and the presence
of health insurance probably explains that inelasticity  of demand for Pharmaceuticals.  The
existence of close substitutes for individual drugs and the pressure to control health care costs,
on the  other hand, probably explains the relative  elasticity of demand for specific drugs.

                                           1-4

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       Because regulatoiy costs associated with new effluent standards can affect a large portion
of the pharmaceutical industry, the industry as a whole might be able to pass through regulatory
costs to consumers in the form of higher drug prices.  Individual companies, however, will have
less latitude in passing through costs, although many specific companies do appear to have
sufficient market power to pass through regulatory costs. Throughout most of the EIA, however,
the conservative assumption that manufacturers cannot pass through compliance costs is used.
1.4    OVERVIEW OF THE EIA METHODOLOGY AND COMPLIANCE COST ANALYSIS

       A number of regulatory options have been developed by EPA and are analyzed in this
EIA. These options  are divided into those for direct dischargers and those for indirect
dischargers. In addition, A and C industry subcategories (representing facilities that use
fermentation or biological and chemical synthesis) are distinguished from B and D industry
subcategories (representing facilities that use biological and natural extractive processes or that
are formulators of pharmaceutical products). For direct dischargers, the technologies are further
broken down into Best Practicable Control Technology Currently Available (BPT), Best
Conventional Pollutant Control Technology (BCT), Best Available Technology Economically
Achievable (BAT), and New Source Performance Standards (NSPS) options; for indirect
dischargers, Pretreatment Standards for Existing Sources (PSES) and Pretreatment Standards for
New Sources (PSNS) technology options are examined.

       Table 1-1 presents the regulatory options addressed in this analysis and defines the
technologies associated with each option.  Although a total of 37 options are evaluated in the
EIA, EPA has selected the following options for inclusion  in the proposed regulation:

       •      For direct discharging A/C facilities, BPT-A/C#2 is selected for conventional
              pollutants and BAT-A/C#2 is required for nonconventional pollutants.
       •      For direct discharging B/D facilities, BPT-B/D#2 is selected for conventional
              pollutants and BAT-B/D#1 is required for nonconventional pollutants.
       •      NSPS-A/C#1 is selected for new A/C facilities that are direct dischargers (this
              option is identical to BAT-A/C#3).
                                           1-5

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                          TABLE 1-1




REGULATORY OPTIONS CONSIDERED IN THE ECONOMIC IMPACT ANALYSIS
Type of
Option
Name
':•'••'• '•'.'';•':•" . ' • : - -
Best
Practicable
Technology
Best
Conventional
Technology*
Best Available
Technology
BPT-A/C#1
BPT-A/C#2
BPT-A/C#3
BPT-A/C#4
BPT-A/C#5
BPT-B/D#1
BPT-B/D#2
BPT-B/D#3
BCT-A/C#1
BCT-A/C#2
BCT-A/C#3
BCT-B/D#1
BCT-B/D#2
BAT-A/C#1
BAT-A/C#2
BAT-A/C#3
BAT-A/C#4
BAT-B/Dtfl
BAT-B/D#2
Description
:;: : ) Direct Dischargers }
Current biological treatment
Advanced biological treatment + cyanide destruction
Advanced biological treatment + cyanide destruction + effluent
filtration
Advanced biological treatment + cyanide destruction + polishing
pond
Advanced biological treatment + cyanide destruction + effluent
filtration + polishing pond
Current biological treatment
Advanced biological treatment
Advanced biological treatment + effluent filtration
Advanced biological treatment + effluent filtration
Advanced biological treatment + polishing pond
Advanced biological treatment + effluent filtration + polishing pond
Advanced biological treatment
Advanced biological treatment + effluent filtration
Advanced biological treatment + cyanide destruction with
nitrification where necessary
Advanced biological treatment + cyanide destruction + in-plant steam
stripping
Advanced biological treatment + cyanide destruction + in-plant steam
stripping/distillation
Advanced biological treatment + cyanide destruction + in-plant steam
stripping/distillation + activated carbon
Advanced biological treatment
Advanced biological treatment + in-plant steam stripping
                           1-6

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                                        TABLE 1-1 (cont)
Type of
Option
Best Available
Technology
(Cont,)
New Source
Performance
Standard
Name
BAT-B/D#3
BAT-B/DS4
NSPS-A/C#1
NSPS-A/C#2
NSPS-B/D#1
NSPS-B/D#2
Description
Advanced biological treatment + in-plant steam stripping/distillation
Advanced biological treatment + in-plant steam stripping/distillation
+ activated carbon
Advanced biological treatment + cyanide destruction + in-plant steam
stripping/distillation
Advanced biological treatment + cyanide destruction + in-plant steam
stripping/distillation + activated carbon
Advanced biological treatment + in-plant steam stripping/distillation
Advanced biological treatment + in-plant steam stripping/distillation
+ activated carbon
''!"•• ':•"••••'-'•• • ".:'•'.'•:. • .'..;.[...'!; ':--.;. :Vx|I&
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        •     NSPS-B/D#1 is selected for new B/D facilities that are direct dischargers (this
              option is identical to BAT-B/D#3).
        •     PSES-A/C#1 is selected for A/C facilities that are indirect dischargers.
        •     PSES-B/D#1 is selected for B/D facilities that are indirect dischargers.
        •     PSNS-A/C#1 is selected for new A/C facilities that are indirect dischargers (this
              option is identical to PSES-A/C#2).
        »     PSNS-B/D#1 is selected for new B/D facilities that are indirect dischargers (this
              option is identical to PSES-B/D#2).

The selected BAT options include all of the processes mandated in the selected BPT options.

        Section Four also presents the overview of the EIA methodology  and describes the
principle economic and financial models used. Figure 1-1 shows how these principle models (the
cost annualization model, the facility closure model, and the  owner company model) operate.

       The cost annualization model estimates the annual compliance cost to the facility of new
pollution control equipment and operations. This model provides the data necessary for the
facility-level analysis.  Annualizing costs is a technique that allocates the capital investment over
the lifetime of the equipment, incorporates a cost-of-capital factor to address the costs associated
with raising or borrowing money for the investment and the tax-reducing  effects of expenditures
(i.e., depreciation allowances allowed on corporate income tax), and includes annual operating
and maintenance (O&M) costs.  The resulting annualized cost represents the average annual
payment that a given company will need to make to  upgrade  its facility.

       The annualized costs for the selected regulatory options are given in Table  1-2 in 1990
dollars. The  average annualized costs per facility are $1.1 million ($1.3 million, 1994 $) for BAT-
A/C#2, $51 thousand ($58 thousand, 1994 $) for BAT-B/D#1, $0.4 million ($0.4 million, 1994 $)
for PSES-A/C#1, and $52 thousand  ($59 thousand, 1994 $) for PSES-B/D#1. The aggregate
annualized costs are $26.8 million ($30.6 million, 1994 $) for  BAT-A/C#2, $0.7 million ($0.8
million, 1994  $) for BAT-B/D#1, $34.6 million ($39.5 million, 1994 $) for PSES-A/C#1, and $7.9
million ($9.1 million, 1994 $) for PSES-B/D#1, for a total aggregate  cost  of $70.0 million ($80.0
million, 1994  $). EPA is also soliciting comments on an alternative regulatory scenario

                                            1-8

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iiudiiciiiai vsapiicu
and O&M Costs
Cost Model) A
1
T
Equipment Lifetime
Discount Rate
Depreciation Rates
Tax Rates

Discount Rate
v t
Net Income
t
nalysis of Recent
Industry Trends
t
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Forecast


Assessed Value
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t
PRESENT VALUE OF
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\

i
SALVAGE VALUE
1


A-B = (-) -^ CLOSURE


A-B = (+) -*- NONCLOSURE

Figure 1-1. Basic facility closure analysis methodology.
                      1-9

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                                        TABLE 1-2

          COMPLIANCE COSTS FOR SELECTED REGULATORY OPTIONS (1990 S)
Option
Number
BAT-A/C22
BAT-B/D#1
PSES-AO1
PSES-B/D#1
Total
Capital Costs
$56,392,127
$644,446
$70,795,915
$25,160,649
Total
O&M Costs
$35,689,088
$1,104,801
$46,441,499
$8,956,179
Total Posttax
Annualized Costs
$26,779,144
$708,758
$34,564,845
$7,922,101
Average
Annual Cost
per Facility*
$1,115,798
$50,626
$392,782
$51,778

Total**
$152.993,1371 $92.191,568
$69,974,848
$250,806
* Total Posttax Aimualized Costs divided by the total number of facilities for each subcategory.
** Total number of facilities includes seven nondischarging facilities.

Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report.

Source: ERG estimates based on Radian Corp. capital and operating costs estimates for pollution control
equipment.
                                            1-10

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comprising BAT-A/C#3, BAT-B/D#1, PSES-A/C#2, and PSES-B/D#2 (the in-plant steam
stripping/distillation regulatory scenario; see Appendix C).  Under this scenario, the total
compliance costs are $111.9 million ($127.9 million 1994 $).
1.5    FACILITY-LEVEL ANALYSIS

       This section discusses the impacts on 282 facilities in the survey universe.1 Of these 282
facilities, 148 facilities are not directly considered by the facility closure model.  These 148
facilities comprise two groups:  certifying facilities and single-facility firms.  These groups and the
reasons they are not directly considered by the model are described below.

       EPA exempted facilities from providing facility-level data if the company owners certified
that the regulation would have no economic impact on the facility (i.e., the rulemaking will be
economically achievable for the company and its certified facilities). Sixty-five facilities (which
represent 72 facilities in the survey universe) certified no impact.  Another 76 facilities in the
survey universe indicated  that their owner firm and the facility are the same entity (i.e., the firm
owns only one facility). In these cases, the firm-level analysis in Section Six was determined to
be the appropriate level at which to evaluate impacts at these facilities.  These 76 "firm/facilities,"
as well as the 72 certifying facilities, are placed automatically in the "no-closure" category by the
facility closure model. This approach avoids double counting of impacts at both the firm and
facility level. Results of the analysis show impacts relative to all 282 facilities in the analysis.

       Facility closures are estimated by comparing the facility's "salvage value" (the expected
amount of cash the owner would receive if the facility were closed permanently and liquidated)
to the  present value of its future earnings (the value in current dollars of the expected stream of
earnings that the facility can generate over a specified period of time).  If the salvage value is
greater than what  the facility is expected to generate in earnings, then it is assumed that the
owner  would liquidate the facility. Salvage value includes the value of current (i.e., short-term)
    *A total of 286 facilities are represented by 244 facilities in the Section 308 survey. Three
survey facilities (representing four facilities in the survey universe) provided insufficient data in
the Section 308 survey and are not included in this  analysis.
                                            1-11

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assets and fixed (i.e., long-term) assets.  Data for the facility-level analysis are either taken
directly from the 308 Pharmaceutical Survey or estimated based on Section 308 data.

       The baseline facility-level analysis indicates that 38 facilities (in the survey universe), or
13 percent of the total number of facilities, will close in the baseline.  The results of the
postcompliance facility-level analysis for selected regulatory options are given in Table 1-3. The
analysis predicts that no facilities will close as a result of any of the selected regulatory options.
The same result is obtained when the alternative regulatory scenario  (steam stripping/distillation)
is considered.
1.6    FIRM-LEVEL ANALYSIS

       The firm-level analysis evaluates the effects of regulatory compliance on companies
owning one or more affected pharmaceutical facilities and identifies other impacts not captured
in the facility analysis.  The analysis assesses the impacts of facility closures on each firm and the
impact of compliance costs at all facilities owned by the firm that do not close.  These impacts
are assessed using ratio analysis, which employs two indicators of financial viability: the rate of
return  on assets (ROA)2 and the interest coverage ratio (ICR)3.  The ratio analysis simulates
the analysis an investor and/or creditor would employ in deciding whether to finance a treatment
system, or make any other investment in the firm. In the baseline ratio analysis, the company's
financial viability before the investment is made is evaluated.  This analysis includes the effects of
any baseline facility closures that might reduce net income and assets.  In the postcompliance
analysis,  the company's financial condition following the investment is predicted.  Data from the
Section 308 survey and engineering costs analyses are used to calculate baseline and
postcompliance ROAs and ICRs. ROA and ICR are computed with the survey data in the
baseline  analysis. In the postcompliance analysis, the relevant survey data (net income, net
income and earnings before interest and taxes [EBIT], total assets, and interest expenses) are
   2Net income divided by total assets.
   3Earnings before interest and taxes divided by interest expense.
                                            1-12

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-------
adjusted to reflect annual compliance costs estimated at the facility level as well as losses in
income caused by postcompliance facility closures, if any.

       To evaluate the baseline viability of the companies analyzed, the baseline ROA and ICR
values are compared against the lowest quartile (25th percentile) values for the pharmaceutical
sector (SIC 283). Those companies for which the value of either the ROA or the ICR is less
than the first quartile value from RMA and D&B are judged to be vulnerable to financial failure.
The baseline analysis indicates that out of 187 firms in the survey universe, 54 (29 percent) are
likely to fail even before the impact of the effluent guideline requirements is considered.

       The standard postcompliance analysis, referred to as Postcompliance Analysis 1, evaluates
impacts on companies that are not found to be vulnerable in the baseline analysis.  For these
healthier companies, if either of the postcompliance ROA and ICR values fall below the first
quartile benchmarks, then the company is judged to be vulnerable to financial failure as a
consequence of regulatory compliance; these companies  are determined to sustain a "significant
impact" as a result of the regulation. Table 1-4 presents the results of Postcompliance
Analysis 1. Postcompliance Analysis 1 indicates that only two firms with A/C indirect discharging
facilities and one firm (a firm/facility) that is a B/D indirect discharging facility4 are expected to
experience significant impacts as a result of compliance costs associated with the selected
regulatory options.  Overall, these firms represent 3.8 percent of all firms with A/C indirect
discharging facilities, 1.4 percent of firms with B/D indirect  discharging facilities,  and 2.3 percent
of all regulated firms that do not fail in the baseline. These results are the same under the
alternative regulatory scenario (in-plant  steam stripping/distillation).

       Postcompliance Analysis 2 examines the relative  percentage change in ROA or ICR as a
result of compliance costs or facility closures associated with the selected regulatory options for
firms that have positive net income and/or EBIT, but whose ROA or ICR fall below benchmarks.
This analysis determines the severity of impact, assuming these firms do not close in the baseline.
A percentage change in ROA or ICR of more than 5 percent is considered a major impact. The
results of the Postcompliance Analysis 2, which are presented in Table 1-5, indicate that  a total
   This firm/facility is counted as a facility closure in later analyses.
                                            1-14

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                                      TABLE 1-4

                          POSTCOMPLIANCE ANALYSIS 1*

Finns with A/C Direct Facilities
Finns with B/D Direct Facilities
Firms with A/C Indirect Facilities
Firms with B/D Indirect Facilities
Total
Number
of Firms
15
7
53
72
No Significant
Impact
#of
Firms
15
7
51
71
%of
Group
100.0%
100.0%
96.2%
98.6%
Significant
Impact
#of
Firms
0
0
2
1
%of
Group
0.0%
0.0%
3.8%
1.4%
% of All
Firms**
0.0%
0.0%
1.5%
0.8%

AllFirms+
133
1301 97.7%| 3
2.3%
2.3%
* This scenario analyzes impacts from regulating A/C Direct facilities under options BAT-A/C#2
and BPT-A/C#2, B/D Direct facilities under options BAT-B/D#1 and BPT-B/D#2, A/C Indirect
facilities under option PSES-A/C#1, and B/D Indirect facilities under option PSES-B/D#1.
** Out of all firms in the postcompliance analysis (133 firms).
+ Number of firms for All Firms might be less than the total firms by subcategory because some
firms have more than one type of facility. Total number of AH Firms includes firms that have
nondischarging facilities

Note: Analysis excludes three firms because of lack of financial data.

Source: ERG estimates.
                                            1-15

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                             TABLE 1-5

                  POSTCOMPLIANCE ANALYSIS 2
1
Range of
Change
0
>0 - <=5
>5 - <=10
>10-<=20
>20 - <=50
Percent Change
inlCR*
# Firms
9
11
2
0
5
>50 I 2
% of Total
31.0%
37.9%
6.9%
0.0%
17.2%
6.9%
Percent Change
in ROA"
# Firms
6
% of Total
30.0%
3 1 15.0%
3
2
2
4
15.0%
10.0%
10.0%
20.0%

Total # Finns
291 100.0%
20
100.0%
* Finns that failed the baseline analysis are analyzed here if [(base EBIT and net
incomeX))and(base ICR or ROA0)3.
Because only firms with positive EBIT can be analyzed here, those with negative
EBIT are analyzed for percent decline in EBIT in Table 1-6.
** Firms that failed the baseline analysis are analyzed here if [(base EBIT and net
income>0)and(base ICR or ROA0)].
Because only firms with positive net income can be analyzed here, those with negative
net income are analyzed for percent decline in net income in Table 1-6.

Source: ERG estimates.
                                      1-16

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 of nine firms, or about 31 percent of marginal firms with positive EBIT, are expected to incur
 substantial impacts measured as percent change in ICR (i.e., greater than 5 percent change) if
 they do not fail for other reasons. In addition, 11 firms (55 percent of the marginal firms with
 positive ROA), are expected to incur substantial  impacts measured as percent change in ROA
 (i.e., greater than 5 percent) if these firms do not fail for other reasons.

       Postcompliance Analysis 3 evaluates firms with negative ROA or ICR ratios. Although
 changes in ROA or ICR ratios that already are negative are difficult to present meaningfully, the
 proportion of the postcompliance net income or EBIT loss attributable to compliance costs
 provides a qualitative sense of impact.  As in Postcompliance Analysis 2, a change of more than
 5 percent is considered a major impact. The Postcompliance Analysis 3 results, which are
 presented in Table 1-6 indicate that six firms (24 percent of firms with negative EBIT) will incur
 substantial impacts if they do not fail for other reasons.  For firms with negative net income in
 the baseline, only five firms (or about 15 percent) are expected to incur substantial impacts if
 they do not fail for other reasons.

       All firms identified as potentially experiencing a major  impact in Postcompliance
 Analyses 2 and 3 are investigated further to determine the likelihood of baseline failure, looking
 at several measures that might indicate the firm is healthier than the baseline analysis might
 indicate. These measures include substantial increases in net income and working capital, high
 research and development expenditures, etc. Any facilities not identified as highly likely to fail in
 this analysis are determined to be a potential upper bound on overall impacts from the proposed
 effluent guidelines.

       Many of the firms in Postcompliance Analysis 2 and 3 overlap in these counts, thus only
 16 firms identified as likely to  fail in the baseline are considered likely to incur major impacts if
 they do not actually fail.  Of these 16 firms, only one is considered to have indications that its
 financial situation is better than the baseline analysis indicates, and thus might not fail in the
 baseline. The firm showed outstanding growth in net income over a 3-year period.  If the last
year (1990) of financial data is assumed to be representative of its future performance, this firm
 not only would not fail in the baseline but also would not fail in the postcompliance analysis.
                                           1-17

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                           TABLE 1-6

                POSTCOMPLIANCE ANALYSIS 3
Range of
Change - "
0
>0 - <=5
>5-<=10
>10 - <=20
>20 - <=50
>50
Percent Change
in EBIT*
# Firms
12
7
1
1
1
3
% of Total
48.0%
28.0%
4.0%
4.0%
4.0%
12.0%
Percent Change
in Net Income**
# Firms
15
14
1
2
1
1
% of Total
44.1%
41.2%
2.9%
5.9%
2.9%
2.9%

Total # Finns
25
100.0%
341 100.0%
* Finns that failed the baseline analysis are analyzed here if (base EBIT<=0).
** Finns that failed the baseline analysis are analyzed here if (base net income<=0).
Source: ERG estimates.
                                    1-18

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 Thus, the results of Postcompliance Analysis 1 are considered the upper bound estimate of major
 firm-level impacts from the selected regulatory options.

       Finally, the Profitability Analysis determines impacts on profitability among firms
 estimated to have no significant impact from compliance costs in Postcompliance Analysis  1.
 This analysis investigates the percentage change in ROA among the financially healthy firms to
 assess impacts on profitability.  Again, a change of more than 5 percent is considered a major
 impact. Table 1-7 presents results from the Profitability Analysis, which indicate that 15 firms
 (not including those projected likely to fail postcompliance) will experience major impacts  short
 of firm failure from the selected regulatory options.  When the 36 firms that certified that  they
 would experience no impacts from any effluent guideline are  included in the count of financially
 healthy firms, only 11 percent of firms in the postcompliance analysis are expected to experience
 major impacts short of firm failure.
1.7    EMPLOYMENT AND COMMUNITY-LEVEL ANALYSIS

       The employment and community-level analysis investigates employment losses,
community-level impacts, and employment gains resulting from compliance with the effluent
guidelines.  Primary and secondary employment losses, which are the primary indicator of
community-level impacts, are measured as a direct result of facility and firm closures.  Primary
employment losses are based on employee layoffs associated with the facility closures estimated
in the facility-level and company-level analyses.  These job losses are estimated from survey data
on annual employment hours, which are then converted into fulltime equivalents  (FTEs).  The
significance of facility employment losses on the community then is measured by  their impact on
the community's overall level of employment. An increase in the community unemployment rate
equal to or greater than 1 percent is considered significant. Secondary impacts are assessed
through multiplier analysis, which measures the extent of impacts in other industries as a
function of impacts in the primary industry.

       The baseline impacts from the analysis on primary employment include 14,381 jobs that
are estimated to be lost, out of a total employment of 147,804 workers (9.7 percent of total

                                          1-19

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 employment in the affected segment of the pharmaceutical industry). The baseline analysis also
 predicts that secondaiy job losses will total 85,567 FTEs, using the industry-specific multiplier of
 5.95.  Under the postcompliance analysis, no employment  losses are projected to occur as a
 result of regulatory options  for direct dischargers. For A/C and B/D indirect dischargers,
 however, total projected primary employment losses are estimated to be 91 out of the 133,423
 FTEs estimated to remain following the baseline analysis,  which is 0.07 percent of total baseline
 employment in the affected segment of the industry. Secondary losses are predicted to be 541
 FTEs, again using the multiplier of 5.95. The actual change in area unemployment rates
 associated with these closures is estimated at less than 1 percent for all affected communities.
 These results are the same under the alternative regulatory scenario (in-plant steam
 stripping/distillation).

       Employment gains are also computed. Additional  employment is likely to be needed to
 account for the increase in demand for pollution control equipment, the need to install the
 equipment and the need to operate the equipment.  On an annual basis, 68 FTEs are expected
 to be  added due  to the  need to manufacture pollution control equipment, 10 FTEs are expected
 to be  added annually as a result of the need to install equipment,  and 889 FTEs are expected to
 be added to maintain the equipment, for a total of 967 FTE primary employment gains.

       Total primary and secondary employment gains are calculated as a  range. The lower end
 of the range assumes that FTEs added to maintain equipment will not materialize  but that losses
 in production hours resulting from the proposed rule that  could not be estimated because of lack
 of data would be absorbed by this increase in labor hours.  The low end of the range also uses
 the lower range of secondary effect multipliers.  The high  end of the range uses all labor gain
 components (manufacturing, installation, and operation) with the high end of the range 'for
 secondary employment multipliers.  Total primary and secondary labor gains  therefore are
 estimated to range between  218 and 2,890 FTEs. The net  effect on primary and secondary
 employment is estimated to  range from a loss of 323 FTEs to a gain of 2,349 FTEs. The net
 employment impact is negligible when compared to national level  employment and will have no
impact on national-level employment rates.
                                          1-21

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       Gains are slightly greater under the alternative regulatory scenario (in-plant steam
stripping/distillation) because of the greater equipment and installation expense.  Overall, under
the alternative regulatory scenario, net employment impacts would range from 272 FTEs lost to
2,421 FTEs gained.
1.8    FOREIGN TRADE IMPACTS

       Pharmaceutical products are traded in an international market, with producers and buyers
located worldwide. Changes in domestic pharmaceutical production due to the effluent
guidelines can therefore affect the balance of trade.  Consequently, the EIA includes a foreign
trade impact analysis.  Using data from the Section 308 Survey, the value of 1990 pharmaceutical
exports.is estimated for facilities expected to close.  These values are summed across facilities to
obtain  an estimate of the total value of U.S. pharmaceutical exports that would no longer be
produced. This value is then compared to the total value of U.S. pharmaceutical exports
produced in 1990.

       The resulting impact of effluent guidelines on pharmaceutical exports and the U.S.
balance of trade is negligible.  The one firm/facility that is predicted to close as a result of the
effluent guidelines has pharmaceutical exports totaling $76 thousand ($87 thousand, 1994  $).
The loss of these exports will have virtually no effect on U.S. pharmaceutical exports, which,
according to the U.S. Department of Commerce, totalled $5.7 billion in 1991 (1991 $). The
results  are the same under the alternative regulatory scenario (steam stripping/distillation).
1.9    REGULATORY FLEXIBILITY ANALYSIS

       A regulatory flexibility analysis has been conducted to ensure that small entities
potentially affected by the new effluent guidelines will not be disproportionately burdened by the
regulation.  In the regulatory flexibility analysis, pharmaceutical firms are defined as small if they
employ fewer than 750 persons.
                                           1-22

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       1.9.1 Financial Profile of Small Firms

       Median total assets and liabilities at the affected pharmaceutical firms rise with size, as
does median net income. On average, small firms tend to have lower ROA than large firms,
although the 500 to 750 employees size group has a considerably higher ROA than firms with
over 750 employees. The poorest performing groups are the 19 to 99 and 100 to 499 employees
size groups, which have a median ROA of 4 percent.

       Average pharmaceutical costs and revenues tend to rise with the size of the firm.
Pharmaceutical revenues comprise 60 percent of total revenues in large firms, whereas in small
firms the proportion rises to as high as 87 percent in the 500 to 750 employees site group,
indicating that these firms hold fewer diverse interest than large firms,  making them more
vulnerable to impacts from the proposed effluent guidelines.

       The proportion of value of shipments exported does not tend to increase with size.  The
19 to 99 employees size group exports the largest portion of the reported value of shipments.
The average percentage for small firms is approximately the same as that for large firms.
       1.9.2 Impacts on Small Firms

       Impacts on small firms measured as firm failure are as follows.  Two of the three firms
that were projected to fail in the firm-level analysis under the selected regulatory options have
fewer than 750 employees. Consequently, two-thirds of the significant firm impacts will be
among small firms, although only 2 percent of small firms are affected in this manner.  In
addition, 14 out of the 15 firms found to experience a significant decline in ROA (over 5
percent) have fewer than 750 employees.  These firms represent about 14 percent of all small
firms.

       When cash flow is analyzed, however, impacts seem less disproportionate.  Except in the
19 to 99 employees category, the total present value of compliance costs as a percentage of the
present value of net income is on average smaller among small  firms than among large firms. It

                                          1-23

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is not surprising that the 19 to 99 employees size group is more heavily affected since it is the
weakest group financially. The median small firm's percentage is lower overall than that for
large firms (0.04 percent vs. 0.25 percent). Overall, for all firms the present value of compliance
costs is less than 1 percent of the present value of net income on average.  Under the alternative
regulatory scenario, these percentages are 0.1 percent for small firms and 0.5 percent for large
firms.

       The above analyses indicate that although small firms do bear a large portion of the
impacts such as firm failures, these impacts are felt by a very small percentage of all small firms.
Additionally, the percentages of the present value of compliance costs to the present value of net
income are expected to be no larger, on average, among small firms than among large firms.
Thus, overall EPA finds that impacts on small firms are not disproportionate to those on large
firms.  This finding would also apply to the alternative regulatory scenario (in-plant steam
stripping/distillation).
1.10   PROJECTED DISTRIBUTIONAL IMPACTS

       For the distributional analysis, the zero cost passthrough assumption is not used.  Instead,
it is assumed that manufacturers will raise pharmaceutical prices in response to increased
regulatory costs. To determine upper bound impacts, it is further assumed that all cost increases
can be passed through to consumers.

       The extent to which drug prices can rise assuming perfectly inelastic demand is
determined as the ratio of total compliance costs to total cost of pharmaceutical production in
the affected facilities and in the pharmaceutical industry as a whole. The results of this analysis
are presented in Table 1-8. The average ratio for the selected regulatory options ranges from 0.2
to 3.4 percent. For all the selected regulatory options, the ratio of compliance costs to total
pharmaceutical costs is 1.6 percent.  Most facilities will incur compliance costs of less than 1
percent of total pharmaceutical costs. A total of 41 facilities (20 percent of all facilities included
in this analysis) will incur compliance costs greater than 1 percent of total pharmaceutical costs.
Only three facilities (1 percent of all facilities) will incur compliance costs greater than 10

                                            1-24

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percent of total pharmaceutical costs.  Finally, approximately 28 percent of all facilities in this
analysis will experience no increase in total pharmaceutical production costs as a result of the
effluent guidelines.  Under the alternative regulatory scenario (in-plant steam
stripping/distillation) the average percentage of compliance costs to total costs is 2.5 percent with
five facilities incurring compliance  costs greater than 10 percent of total costs.

       In this analysis, the impacts of increased drug prices on various demographic groups is
evaluated.  The demographic groups considered include the elderly, the population living under
the poverty level, disadvantaged minorities, the uninsured, and state and federal governments.

       When possible uses for products produced by a sampling of highly affected facilities
(those where compliance costs exceed 10  percent of total pharmaceutical costs) were
investigated, it appeared that children, women, and the elderly were likely to be the major
consumers of many of these  products.  According to Health Insurance Association of America
(HLAA), the groups least likely to have health insurance are hispanics, young adults, and African
Americans; African Americans, hispanics, and children are most likely to be covered by
government insurance, and African Americans, hispanics,  and the elderly are least likely to have
insurance related to employment. Government insurance programs tend to spend less on drugs
and other medical nondurables than do private insurers, according to this same source, and about
93 percent of people with work-related medical insurance have some type of drug insurance.
Thus those who lack any health insurance, those who are covered by government insurance, and
those who are covered by nonwork-related medical insurance might be least likely to have drug
coverage. When the predominant consumers of the products expected to be affected by
potentially sizeable  cost increases are compared to the groups most likely to lack drug insurance,
young adult women, children, and the  elderly are likely to be the most heavily affected by
potential cost increases, if such increases  can be passed through to consumers.

       Because, on average, any potential price increases  are likely to be very low (1.6  percent
on average), impacts on mass consumers  of drugs such as HMOs, governments, and, indirectly,
third-party insurers, should be minimal.
                                           1-26

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 1.11   IMPACTS ON NEW SOURCES

        The selected options for new sources are NSPS-A/C#1, NSPS-B/D#1, PSNS-A/C#1, and
 PSNS-B/D#1. In all cases, the requirements for new sources are more stringent than those for
 existing sources.  However, the difference in cost between new source requirements and existing
 source requirements for typical facilities are relatively small when compared to the average
 facility costs of production. In most cases, existing facilities would be required to retrofit in-plant
 steam stripping systems, whereas new sources would have to install in-plant  steam
 stripping/distillation systems.  Because designing in pollution control equipment in a new source
 is typically less expensive than retrofitting the same equipment in an existing source, the cost
 differential between the selected requirements for existing sources and those higher existing
 source options that are technically equivalent to new source requirements should be an upper
 limit on the differential annual cost faced by new sources. Where this differential is not
 substantial relative to the typical costs of doing business in this industry, no significant barrier to
 entry is likely to exist.

        The average per-facility compliance costs were investigated to determine what the cost
 differentials would be between proposed new source and existing source requirements.  The
 average per-facility cost differentials ranged from about a $34 thousand to a  $590 thousand
 difference (for A/C direct dischargers), depending on the type of facility.  The maximum $590
 thousand ($674 thousand 1994 $) difference generates the highest percentage of compliance cost
 differential to pharmaceuticals manufacturing cost—about 1.4 percent of total manufacturing
 costs and about 3.0 percent of pharmaceutical  manufacturing costs. Since this cost differential is
 likely to be less than that assumed here, this small premium estimated to be  paid by new sources
 is not likely to have much impact on the decision to enter the market. Furthermore, these same
 options, when applied to existing sources, were found to have nearly identical impacts on existing
 sources as the selected options for existing sources. Thus no significant barriers to entry are
 estimated to result from the proposed new source requirements.

       Under the  alternative regulatory scenario (in-plant steam stripping/distillation) only the
 requirements for existing BAT-B/D direct dischargers are less stringent than  those for equivalent
new sources. The  cost differential between BAT and NSPS requirements  is estimated to be $53
thousand ($61 thousand 1994 $), or about 0.1 percent of pharmaceutical or total manufacturing
costs.
                                           1-27

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                                   SECTION TWO
                                  DATA SOURCES
       The EIA relies on a variety of data sources including the Section 308 Pharmaceutical
Survey conducted specifically for this regulatory development effort, the U.S. Department of
Commerce, the U.S. Food and Drug Administration (FDA), Bureau of Labor Statistics (BLS),
Dun & Bradstreet (D&B), Robert Morris Associates (RMA), the Pharmaceutical Manufacturers
Association (PMA), and various journal articles.  Most of the analysis conducted in Sections
Four through Eleven make extensive use of the data collected from the Section 308
Pharmaceutical Survey. Other data sources were used primarily in the development of the
industry profile in Section Three.  Data gathered in the profile,  however, provides the foundation
for much of the analysis in later sections.

       The following sections describe the two principal data sources for this EIA: the Section
308 Pharmaceutical Survey and sources available through the U.S. Department of Commerce.
Other data sources are described, as necessary, in Sections Three through Eleven.
2.1    THE SECTION 308 PHARMACEUTICAL SURVEY

       The Section 308 Pharmaceutical Survey obtained detailed technical and financial
information from a sample pharmaceutical establishments potentially affected by EPA's proposed
effluent guidelines. EPA stratified the industry into five groups based on type of operation:

       •     A) Fermentation
       •     B) Biological  and natural extraction
       •     C) Chemical synthesis
       •     D) Formulation and mixing/compounding
       •     E) Research
                                          2-1

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       The stratification permitted EPA to census (i.e., survey all facilities) facilities within some
subcategories and sample facilities within others.  EPA took a census of all facilities that (1)
manufacture active ingredients (subcategories A, B, C) and directly discharge process wastewater
and (2) perform formulating and mixing/compounding (subcategory D) and directly discharge or
directly and indirectly discharge process wastewater.  EPA judged that a census of these facilities
was necessary to achieve statistical accuracy because the overall universe was small, few facilities
were in the same combination of subcategories, and each facility was expected to have
wastewater generated by proprietary processes that would make their effluent significantly
different from other facilities in the same subcategory. Overall, EPA conducted a census of 202
facilities in these four subcategories (EPA, 1990).

       EPA also censused subcategory D stand-alone facilities that use solvents and discharge
indirectly and subcategory D facilities with onsite  research facilities (i.e., subcategory D/E) that
use solvents and discharge indirectly and have less than 19 employees or more than 747
employees. For subcategory D indirect discharging facilities with between  19 and 168 employees
and between 169 and 747 employees, EPA used a sampling methodology.   The sampling
methodology stratified these facilities by flow rates and employee  size using a linear regression
between the log of the number of employees and log of the flow rate.  Employee and flow rate
data were available from EPA's Development Document for Effluent Limitations Guidelines  and
Standards for the Pharmaceutical Point Source Category (1983). Overall, EPA sampled 42
pharmaceutical facilities in subcategories D and D/E (EPA, 1990). Survey results used
throughout the EIA are weighted according to the sampling plan.  Subcategory D and D/E
facilities with between 19 and 747 employees received a weight of 2  (because only about half of
these facilities were surveyed). (All subcategory D facilities are grouped with subcategory  B
facilities for the purpose of this analysis, which is  discussed in Section Four.) All other facilities
received a weight of 1. The coefficient of variation in any particular strata (i.e., combination of
subcategory and flow group) is no greater than 15 percent.

       EPA determined that no information was needed from three groups of pharmaceutical
facilities:

       »      Facilities that do not discharge wastewater

                                            2-2

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       •      Facilities that do not use solvents and whose only source of process wastewater is
              from formulation and mixing/compounding
       •      Stand-alone research facilities

These facilities do not require effluent guidelines because their impact on water quality and
POTW operations is considered to be negligible.

       The survey data were used extensively in the development of BPT, BCT, BAT, NSPS,
PSES, and PSNS regulations for the industry.  Surveyed facilities provided technical information
on pharmaceutical products; compound and chemical usage and disposition; waste minimization
and pollution prevention activities; wastewater generation, collection, and conservation;
wastewater treatment; steam stripping; and wastewater characteristics. The survey also collected
financial data such as number of employees; ownership structure; discount  rate; market value of
land,  buildings, and equipment; value of shipments; manufacturing costs; assets; liabilities; and
net income. Financial data were collected at the facility, owner-company, and parent company
levels.

       All surveyed facilities were given the option to legally certify that the facility would incur
no significant economic impact as a result of the effluent guidelines.  These facilities gave up
their  right to challenge aspects of the effluent guidelines based on economic achievability so long
as the cost of compliance of the guidelines ultimately promulgated by EPA does not  exceed the
compliance cost estimated in the survey. Certifying facilities were excused  from completing the
bulk of the financial questionnaire. Sixty-five of the 244 surveyed facilities  certified no significant
economic impact and thus did not provide  financial data.
2.2    U.S. DEPARTMENT OF COMMERCE DATA

       The EIA supplements financial data collected in the Section 308 Pharmaceutical Survey
with data from the U.S. Department of Commerce. Commerce divides the pharmaceutical
industry into four 4-digjt Standard Industrial Classifications (SICs):
                                           2-3

-------
       •     SIC 2833 Medicinal and Botanical.  Establishment primarily engaged in : (1)
             manufacturing bulk organic and inorganic medicinal chemicals and their
             derivatives and (2) processing bulk botanical drugs and herbs.

       •     SIC 2834 Pharmaceutical Preparations.  Establishments primarily engaged in
             manufacturing, fabricating, or processing drugs in pharmaceutical preparations for
             human or veterinary use. The greater part of the products of these establishments
             are finished in the form intended for final consumption, such as tablets, capsules,
             liquids, etc. These pharmaceutical preparations  are promoted to the medical
             profession (prescription drugs) and the general public (over-the-counter (OTC)).

       •     SIC 2835 In Vitro and In Vivo Diagnostic Substances. Establishments engaged in
             the manufacturing chemical, biological, and radioactive substances used in
             diagnosing or monitoring human and animal health by identifying and measuring
             normal and abnormal constituents of body fluids or tissues.

       •     SIC 2836 Biological Products, Except Diagnostic Substances. Establishments
             engaged primarily in the production of bacterial  and virus vaccines, toxoids, and
             analogous products, serums, plasmas, and other blood derivatives for human and
             veterinary use.


       Commerce collects a wide range of data at the 4-digjt SIC level including number of
establishments, number of employees,  volume of shipments, exports, imports,  value added,

apparent consumption, manufacturing  costs, and other data.  Commerce further segments the
pharmaceutical into 14 5-digit and hundreds of 7-digit SIC codes. Comprehensive financial data
at the 5 and 7-digit levels, however, is  available only under SIC 2834 Pharmaceutical

Preparations.  Commerce data are reported in publications such as the Census of Manufactures,
County Business Patterns, and U.S. Industrial Outlook.  The EIA uses the most current available
data from these sources in the development of the industry profile in Chapter Three.


       Numerous other data sources employed by the EIA also are organized by SIC code. For
example, price indices generated by BLS are reported according to SIC code. Financial ratio

data reported by D&B and RMA also are organized by SIC.


       A major difficulty with using data organized by SIC, however, is its inability to capture all

establishments engaged in the production of Pharmaceuticals. Commerce classifies facilities  by
their primary line of business. Thus, only establishments that gamer at least 50 percent of their
revenues from pharmaceutical-related  business are classified in the four pharmaceutical SIC
                                          2-4

-------
codes.  Facilities that manufacture Pharmaceuticals but list some other line of business (e.g.,

chemical production) as their primary SIC are not captured in the four pharmaceutical SICs.

facilities that manufacture pharmaceuticals but whose primary business is classified in some other

SIC code.  Thus, Commerce data do not provide a complete picture of the U.S. pharmaceutical

industry.


       The Section 308 Pharmaceutical Survey data cover only a subset of the pharmaceutical

industry.  The five categories used to segment the pharmaceutical industry in the survey do not

correspond with the four pharmaceutical SICs. Moreover, surveyed facilities were not asked to

report their SIC. Thus, no direct comparison can be made between Commerce and survey data.
23    REFERENCES
U.S. EPA. 1990. U.S. Environmental Protection Agency. Supporting Statement for OMB
Review: Detailed Questionnaire for the Pharmaceutical Manufacturing Industry. Washington,
D.C.: Office of Water Regulations and Standards.

U.S. EPA. 1983. U.S. Environmental Protection Agency. Development Document for Effluent
Guidelines, New Source Performance Standards, and Pretreatment Standards for the
Pharmaceutical Manufacturing Point Source Category. Washington, DC: U.S. EPA.
                                         2-5

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                                 SECTION THREE
              PROFILE OF THE PHARMACEUTICAL INDUSTRY
       This profile of the U.S. pharmaceutical industry provides statistical and descriptive
information necessary for developing the EIA methodology presented in Section Four and for
interpreting its results. This section is organized into six subsections that address the principal
determinants of supply and demand for U.S. pharmaceuticals and present key industry statistics.
The section begins with an introduction to the pharmaceutical industry—its products, regulatory
environment, and manufacturing processes. Section 3.2 presents basic facility, owner company,
and parent-level statistics including number of facilities, employment, value of shipments,
international trade, production costs, and baseline financial conditions. Finally, Section 3.3
discusses market structure and demand in the pharmaceutical industry. Key topics such as
barriers to entry, vertical integration, industry concentration, and the price elasticity of
pharmaceutical demand are covered. The section concludes with an analysis of the industry's
ability to raise prices in response to increased regulatory costs.
3.1    OVERVIEW OF PHARMACEUTICAL PRODUCTS, REGULATIONS, AND
       MANUFACTURING PROCESSES
       The EIA will rely on three principal schemes for segmenting the pharmaceutical industry.
As explained in Chapter Two, much of the available EIA data is categorized by either U.S.
Department of Commerce's SIC code (SICs 2833,2834, 2835, and 2836) or by EPA's five
manufacturing subcategories representing the industry's principal manufacturing processes. In
addition, the industry can be segmented according to major drug types and the regulations that
govern their manufacture and sale. This section introduces the reader to the industry's products
and regulatory environment (Section 3.1.1) and provides a synopsis of the industry's principal
manufacturing processes (Section 3.12).
                                        3-1

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       3.1.1 Pharmaceutical Products and Regulations

       One of the more convenient means for categorizing the more than 110,000
pharmaceutical products currently on the market is by using regulatory definitions. The
pharmaceutical industry is regulated by a variety of state and federal agencies that play a major
role in nearly all aspects of pharmaceutical production from drug research and development to
manufacturing and marketing. At the core of pharmaceutical regulation is the FDA, which is
charged with ensuring the safety and effectiveness of drugs intended for human and animal use.
To this end, FDA reviews drugs before they  reach the market, monitors clinical trials, dictates
labeling requirements, specifies acceptable manufacturing practices,  and conducts postmarket
surveillance. The industry also is directly regulated by other federal and state agencies such as
the Occupational Safety and Health Administration  (OSHA) and EPA. Other federal and state
governments, acting through the Medicare and Medicaid programs as major third-party payers of
prescription drugs, also have considerable influence  on the industry (see Section 3.43). In
addition, federal and state governments (1) purchase large quantities of pharmaceutical products
through the U.S. Public Health Service and the Veterans Administration (VA), (2) sponsor
pharmaceutical research and development (R&D) through the National Institutes of Health
(NIH), and (3) influence product development through tax policy.

       Pharmaceutical manufacturers must obtain FDA approval before marketing a drug in the
United States. For review purposes, FDA groups drug marketing applications into one of three
categories—new drugs (i.e., patented, branded drugs), generic drugs, and over-the-counter (OTC)
drugs—according to the following guidelines:

       •      A new drug can be either an  entirely new molecular entity (NME); a new ester,
              salt, or other noncovalent derivative;  a new formulation; for a new indication; or  a
              new combination (see Figure 3-1 for  definitions of these terms).
       •      Generic drugs are equivalent versions of previously marketed, patented
              prescription drugs and generally appear on the market several years after patent
              expiration.
       •      OTC drugs are available without a prescription and generally undergo a less
              rigorous review process. Examples include aspirin, cough medicines, and home
              pregnancy tests.
                                           3-2

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 New molecular entity (NME).  A drug for which the activejmoiety ^{either as the unmodified: base
 compound or aniester, salt, clathrate, or other noncovalent derivative ofthe"base compound).has not
 been previously approved or marketed In the United States for use. ir* ;a 'drug.prodiict,: either^as:.a   :
 single ingredient or as part of a combination product, or as part of admixture of sterepisoiheis.

 New esterv salt^ or other uoncovalent derivative,  A drug fpt whle^ithe active.moiety hasbeen;:
 previously approved/or marketed in the United States, but for whicfr ifie particular estef,:salt,::;:;   :
 clathrate, or fither noncovalent derivafive, or the unmodified base cornpound is ;npt:yet;^prpved pr;=
 marked in the:T|nited States,, either as a single ingredient, part o^;a| combination product, oirpari of
 a mixture of steiceoisbmers:,                               :                  ...••-...••.

 New jformulation, A new dosage form or  formulation, including a new strength, whiere:the::drug:  j
 rias-already, been^approved or marketed in the United States by.the/sameof .another manbfactiirer.
 The;indication may ;be the same as for the already market^ ;dHi|:produc:t: or^ may toelnew.    .     !

 New:;combinatipn. !A drug product containing two or more.active. rridieties:;thathave^ not bebn: |', '"••
 previously approvedior marketed together in a. drug product by:any manufacturer ^nymeUnitpl |    :
 States. ,The: new .prdduct may be a physical or a chemical (ester driponcpyalent) combinalion of::.
 two or more active moietiesj                                    i               ;       ••  • I    I

 New indication. The product duplicates a  drug product (same active mbiety.rsaines salt, sarne^!.: -: !
 fermulation,; or same combination) already  approved or marketed 3n1tfie:United'.States, by the^
 or another firm :ekcept thai it provides for a new use.             :                 :
Figure 3-1. New drug definitions.

Source: FDA, 1992.
                                            3-3

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As can be seen in Figure 3-2, new drugs accounted for the majority (53.3 percent) of industry
sales in 1991. OTC drugs accounted for 34.1 percent of sales and generic drugs made up the
remaining 12.6 percent.1

       Each of these three major drug types face differing market conditions. The presence of
patents  and other barriers to market entry create monopolistic conditions in the sales of branded,
patented drugs, whereas in other markets, the presence of generics create classic competitive
conditions. Competition among and within these drug groups and other issues concerning market
structure in the pharmaceutical industry are discussed in detail in Sections 3.4 and 3.6. The
following three subsections introduce the reader to the major drug types and regulations that
affect their manufacturing and sale.
       3.1.1.1 New Drugs

       FDA has classified approximately 90 percent of all drugs marketed since 1938 as "new
drugs," requiring manufacturers to submit New Drug Applications (NDA) to FDA containing
clinical and other data demonstrating the drug's safety and effectiveness. Because they have
never been marketed before, new drugs receive the most scrutiny from FDA and undergo a
lengthy review process to determine whether the drug is safe and effective in its intended use.

       According to FDA data, the agency has approved an average of 90 new drugs each year
since 1982 (see Figure 3-3). Approximately 26 percent  of the new drugs approved each year are
NMEs. The agency also  approves, on average, some 1,207 new drug supplements, which
represent a change to an already approved drug such as adding a new indication (approved use),
revising an approved indication, and other changes. FDA approves approximately 60 percent of
all new drug applications (NDAs) and supplements received each year (FDA, 1992). Figure 3-4
presents  a breakdown of new drugs approved between  1987 and 1992 by major therapeutic
category.
    xFor the purposes of this analysis, biologies and veterinary drugs, which undergo separate review
processes, will be considered subsets of new drugs and generics. In 1990, they accounted for 8.5
percent of the U.S. pharmaceutical market.
                                           3-4

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     To prioritize NDAs for review, FDA classifies new drugs according to their potential
therapeutic importance. Type A drugs represent drugs that might provide effective therapy or
diagnosis for a disease that is not adequately treated or diagnosed by any marketed drug. Type B
drugs have modest advantages over currently marketed drugs such as greater patient convenience
and fewer side effects. Type C drugs have substantially equivalent therapeutic benefits as already
marketed drugs. Approximately 22 percent of the new drugs approved by FDA between 1987 and
1992 were classified as either Type A or B, representing potentially significant therapeutic gains
(FDA, 1992).
       3.1.1.2 Generic Drugs

       When the patent on a prescription drug runs out, other manufacturers often enter the
market with a generic version of the drug. To gain market approval, manufacturers of generic
drugs must prove to FDA through an abbreviated NDA (ANDA) that their product is
"bioequivalent" to a previously marketed drug. FDA defines bioequivalent drugs as drugs with
identical active chemical ingredients and that enter the bloodstream at the same rate and levels.
Because demonstrating bioequivalence is generally much easier than proving the overall safety
and effectiveness of a drug (FDA assumes that bioequivalency implies identical safety and
effectiveness), generic drugs are generally approved much more quickly than new drugs.2
Nonetheless, bioequivalence testing may take several years to complete. Currently, FDA is
averaging about 240 ANDA approvals per year (Sherwood, 1993).

       Although generic drugs accounted for 12.6 percent of total pharmaceutical sales in 1991,
they accounted for 34 percent of all prescriptions filled (NatWest, 1992). Since 1980, generic
drugs have captured an increasing share of the prescription drug market. As  shown in Figure 3-5,
generic drugs accounted for 19.1 percent of prescription drug sales in 1991, almost double their
   2Before 1984, manufacturers of generic drugs would often need to duplicate many of the original
manufacturer's clinical tests to gain market approval. The 1984 Drug Price Competition and Patent
Term Restoration Act (the 1984 Price Act) rescinded these strict controls for generics, stipulating
that generic drug manufacturers need only demonstrate bioequivalence to a previously marketed
drug. It is generally agreed that the 1984 Price Act has greatly facilitated the entry of generics into
the pharmaceutical market.

                                            3-8

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market share in 1980. With rising health care costs, public and private insurers have put
increasing pressure on health care providers to use less expensive generic drugs when available.
According to industry analysts, the generic drug industry is poised to accumulate even greater
market share over the next decade as brand-named drugs representing current annual sales of
over $20 billion lose patent protection between now and 1996 (NatWest, 1992).
       3.1.1.3  OTC Drugs

       FDA treats OTC drugs somewhat differently than other regulated pharmaceutical
products. Before 1976, OTC drugs were not subject to the same NDA requirements. In 1976,
however, FDA revised its OTC policy, calling for more rigorous regulation of the OTC market.
In the same year, FDA embarked on an extensive review of all FDA approved ingredients of
OTC drugs. FDA divided the previously broad grouping of OTC drugs into distinct therapeutic
categories (e.g., sleeping aids, cough suppressants), each with its own monograph standard
requiring specific labeling and dosages. In its review of OTC ingredients, FDA has removed
many previously approved ingredients from the list of approved OTC ingredients. Once FDA's
review  is complete, new OTC drugs that have not been monographed will have to submit safety
and effectiveness data to FDA, much like that required in an NDA.

       Like generics, OTC drugs are a growing segment of the overall pharmaceutical market.
OTC trade organizations expect the OTC market share to increase over the next decade as FDA
increasingly grants OTC status to prescription drugs and as the move to control health care costs
leads to greater use of less expensive OTC products. Within the OTC market itself, analgesics
account for approximately 39 percent of total sales, cold medications 19 percent, and antacids 14
percent. Other OTC products such as antinausea drugs and cough medicines make up the
remainder of the OTC market.
                                          3-10

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       3.1.2  Manufacturing Processes

       The pharmaceutical industry uses an array of complex batch-type processes and
technologies in the manufacture of its products.3  In general terms, the production of
Pharmaceuticals occurs in three main stages: R&D; fermentation, extraction, and chemical
synthesis; and formulation (see Figure 3-6 for a schematic diagram of these three stages). These
manufacturing processes correspond to EPA's subcategorization scheme  (see Section Two).
       3.13.1 Stage I

       Stage I—R&D—encompasses several fields, including chemical, microbiological, and
pharmacological research. A typical pharmaceutical company employs specialized personnel with
expertise in medicinal, organic, and analytical chemistry; microbiology; biochemistry; physiology;
pharmacology; toxicology; chemical engineering; and pathology. The development of a new drug
involves innumerable laboratory processes and years of experimental testing. The entire R&D
process can take as long as  12 years to complete.4
       3.7.2.2 Stage II

       Stage II—Fermentation, Extraction, and Chemical Synthesis—covers the conversion of
organic and chemical substances into bulk active ingredients. Three of EPA's pharmaceutical
industry categories (subcategories A, B, and C) correspond to these three conversion processes.
The processes are defined as follows:5
    3For a detailed discussion of pharmaceutical manufacturing processes, please refer to EPA's 1982
and 1983 proposed and final development documents (U.S. EPA, 1982; U.S. EPA, 1983). These
sources are the basis for much of the discussion in Section 3.1.2.
    *See Section 3.2.3 for a more detailed discussion of pharmaceutical R&D.
    5The following definitions are adapted from Guides to Pollution Prevention: The Pharmaceutical
Industry. U.S. EPA, 1991.

                                           3-11

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STAGE I
             Research & Development
STAGE II
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Fifter -^ Prodpu;


Sludge
W
ibcategory B: N
ganic 	
Ivents 1
f
-$>• Extraction -^
Sludge
Subcategory
tents
r Solvent Vap


T
Chemicals *
Cooling Water Out
                                              f
                                    Organic
                                   Solvents   1
                                            W
                                          Precipitated
                                             ±
                                          Wastewater
                                                          Active
                                                         Ingredient
                                                              To Compounding &
                                                                Formulation
                                                       VOC Emission
                                         Active
                                        Ingredient
                                                                 Wastewater
                                                                             T	H,
                                                                  To Compounding &
                                                                    Formulation
                                            Solvent
                                                            Sludge
                                                                                     Active
                                                                                    Ingredient
                                                            To Compounding &
                                                               Formulation
STAGE
   Subcategory D: Compounding & Formulation

 Non-Contact               Solvent Emission
Cooling Water
              . Excipients &       4    	Organic
                Binders        T   i    Solvents
                 Active
                Ingredient
                 (Drug)
                                                   4    	Organic     	
                                                   T   X    Solvents    ms
 Water*
Detergents
                                                Tableting &
                                               Encapsulation
                                                Washing
                                               Equipment
                                Finished Product to Distribution


        Figure 3-6.  The three stages of pharmaceutical production.
        Source:  Adapted from EPA, 1992.
                                              3-12

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              Fermentation (SubcategoryA). Fermentation processes consist of two major steps:
              inoculation (the introduction of a pathogen into a living organism to stimulate the
              production of antibodies) and seed preparation and fermentation, followed by
              crude product recovery and purification. The process begins in the lab with a
              carefully maintained population of a microbial strain. A few cells from this culture
              are matured into a dense suspension and then transferred to a seed tank designed
              for maximum cell growth. Material from the seed tank is then transferred to a
              vessel for fermentation. Following cell maturation, the fermenter broth is filtered
              to remove solid residues. The filtrate is then processed to recover the desired
              product using solvent extraction, precipitation, and ion exchange or adsorption
              chromatography. Steroids, Vitamin B^ and antibiotics are typically produced
              using a batch fermentation process.

              Extraction  (Subcategory B). Biological, or natural, extraction produces
              Pharmaceuticals from natural material sources such as roots, leaves, and animal
              glands. Product recovery and purification processes include precipitation  and
              solvent extraction. The amount of finished  drug product is quite small compared
              with the volume of natural source material used. During each process step, the
              volume of material worked greatly diminishes to the point where final purification
              might occur on volumes of less than one-thousandth of the initial volume.
              Anticancer drugs, insulin, morphine, and hormones are examples of drugs
              manufactured using natural extraction processes.

              Chemical Synthesis (Subcategory C). Chemical synthesis takes place in a series of
              reaction, separation, and purification steps. Numerous types of chemical reactions,
              recovery processes, and chemicals are used to produce drugs through chemical
              synthesis. Chemicals used in chemical synthesis operations range widely and
              include organic and inorganic reactants and catalysts and a variety of solvents
              listed as priority pollutants by EPA. Most drugs today are produced by chemical
              synthesis. Examples include aspirin and acetaminophen.
       A substance that is fermented, naturally extracted, or chemically synthesized might

require no further processing to become a bulk active ingredient. Alternatively, additional
chemical synthesis might be necessary before the desired active ingredient is formed. Of the
facilities included in the Section 308 survey, 59 percent were engaged in one or more of the
above processes.
       3.12.3 Stage HI


       Stage in—Formulation—refers to the combining of bulk active ingredients with other
substances to produce dosage forms suitable for human or animal intake. Formulation
                                           3-13

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corresponds to EPA subcategory D and can be defined as the preparation of dosage forms into
tablets, capsules, liquids, parenterals (introduced otherwise than by way of the intestines), and
creams and ointments. Tablets account for 90 percent of all medications taken orally and are
produced by blending active ingredients with fillers such as starch or sugar and binders such as
corn starch. Hard and soft capsules consist of gelatin capsules that are filled with an active
ingredient.  Liquid dosage forms include syrups, elixirs, suspensions, and tinctures, all of which
                                           >
are prepared by mixing solutes with a selected solvent in a glass-lined or stainless steel vessel.
Parenterals are injected into the body and are  prepared as solutions, dry solids, suspensions, dry
insoluble solids, and emulsions. Ointments and creams are semisolid dosage forms prepared for
topical use. Approximately 68 percent of the surveyed facilities had formulating operations.

      Following formulation, finished drugs are distributed to hospital formularies, health
maintenance organizations (HMOs), retail pharmacies, and directly to consumers.
3.2    FACILITY, OWNER COMPANY, AND PARENT COMPANY CHARACTERISTICS

       This section presents facility, owner company, and parent company data for the
pharmaceutical industry garnered from the U.S. Department of Commerce and the Section 308
Pharmaceutical Survey. The data cover numbers of establishments and employees, value of
shipments, international trade, production costs, and baseline financial conditions. For the
purposes of this EIA, a facility is defined as an individual location where pharmaceutical
products  are manufactured and/or formulated. An owner company might control one or several
individual facility locations. Owner companies might, in turn, be owned by a parent company.
The U.S. Department of Commerce collects data only at the facility level;  the Section 308
Pharmaceutical Survey, however, collected financial data at all three levels. As discussed in
Section Two, U.S. Department of Commerce data is more representative of the industry as a
whole, whereas the survey data are more representative of the potentially regulated community.
Each of the following sections begins by discussing U.S. Department of Commerce data, where
available, and then follows with  parallel survey  data.
                                          3-14

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       3.2.1  Number of Establishments and Employees

       33.1.1 US. Department of Commerce Data

       In 1990, the U.S. Department of Commerce classified some 1,343 establishments (i.e.,
facilities) involved in producing SIC 283 drugs (see Table 3-1).6 Approximately half of these
establishments (51 percent) were producing SIC 2834 drugs (pharmaceutical preparations), with
the remaining establishments divided among SICs 2833, 2835, and 2836. These pharmaceutical
establishments employed 183,000 people in 1990, an increase of 6.1 percent over 1987
employment levels (see Table 3-2). A little less than half of the industry's workforce is involved
in production. As with the number of establishments, industry employment is heavily
concentrated in SIC 2834, with nearly 80 percent of total industry employment concentrated in
pharmaceutical preparation. As seen in Table 3-2, employment continued to grow in SIC 2834 in
1991 and 1992.

       Smaller establishments (less than 100 employees) dominate the pharmaceutical industry,
accounting for 78 percent of all establishments in SIC 283 in 1990. Almost half of all
establishments employ fewer than 20 people. The industry, however, does have an unusually high
percentage of establishments with more than 250 employees (11 percent) when compared to the
manufacturing sector overall, in which only 4 percent of establishments have more than 250
employees. As discussed in Section  3.5, the presence of an unusually high percentage of large
firms in the industry can be attributed to the enormous financial commitment  necessary to
develop and market new products and the existence of economies of scale in pharmaceutical
manufacturing.
   6In reality, there are probably more establishments manufacturing Pharmaceuticals than are
indicated by U.S. Department of Commerce data. Because U.S. Department of Commerce classifies
facilities by their primary line of business, the four pharmaceutical SIC codes do not capture facilities
that manufacture pharmaceuticals but whose primary business is classified in some other SIC code.
                                         3-15

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                                TABLE 3-1

               NUMBER OF PHARMACEUTICAL ESTABLISHMENTS
                     BY EMPLOYEE SIZE: SIC 283 DRUGS
                                  (1990)
SIC Code
283 Drugs
2833 Medicinals and
Botanicals
2834 Pharmaceutical
Preparations
2835 Diagnostic
Substances
2836 Biological
Products, Except
Diagnostics
Total Number of
Establishments
1^43
266
680
161
220
Number of Employees
1-19
632
133
288
60
97
20-99
416
68
202
56
88
100-249
141
13
78
26
24
>250
154
12
112
19
11
Source:  U.S. Department of Commerce, 1990.
                                    3-16

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                                 TABLE 3-2

          TOTAL NUMBER OF EMPLOYEES AND PRODUCTION WORKERS
                               SIC 283 DRUGS
                                 (1987-1992)
SIC Code
1987
1988
1989
1990
1991*
1992*
Total Employment
SIC 283 Drugs
SIC 2833 Meditinals and
Botanicals
SIC 2834 Pharmaceutical
Preparations
SIC 2835 Diagnostic
Substances
SIC 2836 Biological
Products,
Except
Diagnostics
172,000
11,600
132,000
15,400
13,300
175,000
11,300
133,000
16,200
13,700
184,000
11,400
142,000
16,100
14,500
183,000
10,900
144,000
14,900
13,300
NA
NA
148,000
NA
NA
NA
NA
152,000
NA
NA
Production Workers
SIC 283 Drugs
SIC 2833 Medicinals and
Botanicals
SIC 2834 Pharmaceutical
Preparations
SIC 2835 Diagnostic
Substances
SIC 2836 Biological
Products,
Except
Diagnostics
79,600
6,100
59,900
6,800
6,800
81,000
6,200
60,800
7,500
6,500
82,800
6,600
62,400
6,800
7,000
81,400
6,500
61,500
6,600
6,800
NA
NA
63,400
NA
NA
NA
NA
64,200
NA
NA
* Estimated
NA = Not Available
Source: U.S. Department of Commerce, 1993.
                                    3-17

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       33.1.2  Section 308 Pharmaceutical Survey Data

       EPA estimates that approximately 286 of the industry's 1,343 establishments are either
direct or indirect dischargers and therefore potentially would be affected by revised effluent
regulations.  The Section 308 survey censused or sampled 244 of these establishments to
represent the 286 facilities.  Of the 286 facilities 73 percent are owned by other companies. Only
27 percent of the surveyed facilities indicated that they were independently owned. In 1990, 69
parent companies owned 56 percent of the surveyed establishments.

       Employment data were collected at the facility level only (see Table 3-3). According to
the survey data, only 6 percent of all establishments had fewer than 20 employees. This pattern is
in contrast to U.S. Department of Commerce data, which indicates that almost half of all
pharmaceutical establishments employ fewer than 20  employees. Conversely, where  U.S.
Department of Commerce reports that only 11 percent of pharmaceutical establishments have
more than 250 employees, nearly 55 percent of the surveyed establishments  reported employment
of over 250 people. Approximately 70% of manufacturing employment is concentrating in
pharmaceutical manufacturing among the surveyed facilities. Over 50% of the surveyed facilities
reported no employment in nonpharmaceutical related activities.
       3.2.2 Value of Shipments

       322.1  VS. Department of Commerce Data

       According to the U.S. Department of Commerce, drug industry shipments increased more
than 8 percent in 1992 to $64.1 billion, an estimate that includes all products shipped by
establishments classified in SICs 2833 through 2836. Shipments of drug products alone totaled
$48.3 billion in 1991. In current dollars, drug industry shipments have grown at a rate of 9 to 12
percent since 1987. In real terms, growth has averaged 2 to 4 percent annually. Table 3-4 lists
total industry shipments  (1987 $) and drug product shipments between 1987 and 1992. The data
indicates  that the industry performed well despite the recent recession.
                                          3-18

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                         TABLE 3-3




      SURVEYED FACILITIES BY NUMBER OF EMPLOYEES
Number of Employees
1-19
20-99
100-249
250-500
501-999
>1000
Total
Number of Facilities
18
57
55
54
57
45
286
Percentage of All
Facilities
6%
20%
19%
19%
20%
16%
100%
Source: Section 308 Pharmaceutical Survey.
                            3-19

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                                     TABLE 3-4

               VALUE OF SHIPMENTS: SIC 283 DRUGS ($1987 Millions)
SIC Code
1987
1988
1989
1990
1991*
1992*
1993**
Industry Shipments!
SIC 283
Drugs
SIC 2833
Medicinals and
Botanicals
SIC 2834
Pharmaceutical
Preparations
SIC 2835
Diagnostic
Substances
SIC 2836
Biological
Products, Except
Diagnostics
$39,263
$3,350
$32,094
$2,205
$1,614
$40,942
$3,960
$32,988
$2,237
$1,757
$41,998
$4,213
$33,581
$2,275
$1,929
$42,773
$4,274
$34,144
$2,282
$2,073
$43,723
$4,359
$34,998
$2,316
$2,050
$44,751
$4,406
$35,872
$2,362
$2,111
$46,881
$4,538
$37,737
$2,432
$2,174
Product Shipmentsft
SIC 283
Drugs
SIC 2833
Medicinals and
Botanicals
SIC 2834
Pharmaceutical
Preparations
SIC 2835
Diagnostic
Substances
SIC 2836
Biological
Products, Except
Diagnostics
$35,283
$4,224
$26,610
$2,683
$1,765
$36,939
$4,721
$27,214
$3,030
$1,974
$37,753
$4,781
$27,443
$3396
$2,132
$38,649
$5,030
$27,264
$3,924
$2,431
$39,499
$5,141
$27,864
$4,101
$2,484
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
*  Estimated.
** Forecast.
t  Value of all products and services sold by establishments in the pharmaceutical industry.
tt Value of products classified in the pharmaceutical industry produced by all industries.

Source:  U.S. Department of Commerce, 1993.
                                        3-20

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        Table 3-5 presents value of shipment data by size of establishment (i,e., by number of
employees). As might be expected, the industry's sales are concentrated in larger establishments.
In 1987, for example, the 70 establishments with more than 500 employees accounted for 54
percent of the industry's value of shipments. Conversely, the 696 establishments with fewer than
20 employees accounted for only 2 percent of total industry shipments. Shipments per employee
increased across size classes, indicating the possible presence of economies of scale (see
Section 3.52).

       The bulk (80 percent) of industry shipments is attributed to SIC 2834 Pharmaceutical
Preparations, which in 1992 had sales totaling $35.9 billion (see Table 3-4). For SIC 2834, the
U.S. Department of Commerce further breaks down shipments into five-digit SIC codes
representing individual therapeutic categories. Table 3-6 presents value of shipments data for
nine therapeutic categories within SIC 2834. As can be seen, approximately 71 percent of SIC
2834 shipments are for prescription drugs, 24 percent for OTC drugs, and 5 percent for bulk
shipments. OTC drugs account for the greatest portion of shipments in SICs 28349,
pharmaceutical preparations for veterinary use;  28346, pharmaceutical preparations acting on the
skin; and 28344, pharmaceutical preparations acting on the respiratory system.
       332.2 Section 308 Survey Data

       The Section 308 survey collected data on pharmaceutical and nonpharmaceutical
revenues at the facility, owner company, and parent company levels.7 Only 212 facilities reported
revenues for all 3 years surveyed.8 As shown in Table 3-7, these 212 facilities generated $21.2
billion in revenues in 1990, an average of approximately $100 million per facility. Pharmaceutical
revenues accounted for over 80 percent of total revenues. Table 3-8 shows the distribution of
facilities by pharmaceutical, nonpharmaceutical, and total revenues. Over 62% of the facilities
reported having no nonpharmaceutical revenues at all.
   7Unless otherwise noted, all revenue data is reported in 1990 dollars.
   8It has not been determined why so many of the surveyed facilities failed to report revenues for
all three years surveyed.
                                           3-21

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                                 TABLE 3-5

     VALUE OF SHIPMENTS BY EMPLOYEE SIZE OF ESTABLISHMENT:  SIC 283
                              (Millions of 1987$)
Employee Size
<20 employees
20-99 employees
99-500 employees
>500 employees
Number of
Establishments
696
390
200
70
Number of
Employees
4,800
17,200
43,200
104,700
Value of
Shipments
$757.4
$2,620.8
$12,136.1
$23,748.0
Value of
Shipments Per
Employee
$0.16
$0.15
$0.28
$0.28
Source:  U.S. Department of Commerce, 1991a.
                                   3-22

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                                           TABLE 3-7

              FACILITY, OWNER COMPANY, AND PARENT COMPANY REVENUES
                                       (Billions of 1990$)
Production Cost Category
1988
Total
Average
1989
Total
Average
1990
Total
Average
Fadlities (n = 212)
Revenues from sales of
pharmaceutical products (domestic
and international)
Nonpharmaceutical sales
Total revenues*
$13.4
$3.4
$16.8
$0.06
$0.02
$0.08
$14.6
$4.0
$18.6
$0.07
$0.02
$0.09
$17.0
$4.2
$21.2
S0.08
$0.02
$0.10
Owner Companies (n = 157)
Revenues from sales of
pharmaceutical products (domestic
and international)
Nonpharmaceutical sales
Total revenues*
$42.6
$42.6
$86.9
$03
$03
$0.6
$44.4
$48.2
$94.4
$03
$03
$0.6
$48.8
$48.9
$99.8
$03
$0.3
$0.6
Parent Companies (n = 68)
Revenues from sales of
pharmaceutical products (domestic
and international)
Nonpharmaceutical sales
Total revenues*
$73.3
$213.7
$2923
$1.1
$3.1
$43
$80.6
$215.1
$295.7
$1.2
$3.2
$43
$80.7
$218.7
$305.2
S1.2
$3.2
S4.5
'Pharmaceutical revenues and nonpharmaceutical revenues might not add to total revenues because of inconsistencies in survey
reporting.

Source:  Section 308 Pharmaceutical Survey.
                                                 3-24

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                                     TABLE 3-8

                       DISTRIBUTION OF SURVEYED FACILITIES
                           BY VALUE OF SHIPMENTS: 1990
                                     ($ Millions)
Value of Shipments
0
>0-1
>l-5
>5-25
>25-100
> 100-250
>250
Pharmaceutical
Shipments
Number
3
2
29
64
50
31
15
%
1%
1%
14%
30%
24%
15%
7%
Nonpharmaceutical
Shipments
Number
132
15
9
25
21
8
2
%
62%
7%
4%
12%
10%
4%
1%
Total Shipments
Number
3
11
17
65
62
36
18
%
1%
5%
8%
31%
29%
17%
8%
Source: Section 308 Pharmaceutical Survey.
                                         3-25

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       Company-level pharmaceutical revenues in the sample totaled $42.6 billion in 1988, $44.4
billion in 1989, and $48.8 billion in 1990 (see Table 3-7).' Total company-level revenues in the
sample (including nonpharmaceutical revenues) totaled $86.9 billion in 1988, $94.4 billion in
1989, and $99.8 billion in 1990. Average revenues remained essentially flat over the period at
approximately $600 million per owner company. Owner companies in the sample generated close
to 50 percent of total revenues from Pharmaceuticals.10

       Parent company pharmaceutical revenues in the sample totaled $73.3 billion in 1988,
$80.6 billion in 1989, and $80.7 billion in 1990. Total revenues reported by parent companies
included in the survey came to $292.3 billion in 1988, $295.7 billion in 1989, and $305,2 billion in
1990. In 1990, parent companies generated 27 percent of their revenues from the sale of
Pharmaceuticals.

       Table 3-9 shows the distribution of surveyed owner companies and parent companies by
total revenues. Approximately one-third of the owner companies reported revenues of less than
$25 million, one-third reported between $25 and $200 million, 21 percent between $200 million
and $1 billion, and the remaining 13 percent over $1 billion. Approximately one third of the
parent companies sampled reported revenues of less than $250 million, 16 percent between $250
million and $1 billion, 35 percent between $1 billion and $10 billion, and  16 percent over $10
billion.
       3.2.3 Production Costs

       The following section presents manufacturing, research and development, and
promotional cost data for the pharmaceutical industry.11 Research and development and
   'Approximately 42 percent of the owner companies surveyed derive 100 percent of their revenues
from pharmaceutical sales.
   "Company-level revenues from the survey and U.S. Department of Commerce are not directly
compared because foreign revenues are treated differently.
   "Unless otherwise noted, all cost data is presented in 1990 dollars.

                                          3-26

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                                TABLE 3-9

            NUMBER OF SURVEYED OWNER COMPANIES AND PARENT
                    COMPANIES BY TOTAL REVENUES: 1990
                                ($ Millions)
Owner Companies
Total Revenues
$0-$25
>:$25-$200
.>$200-$1,000
^$1,000
Number of
Companies
50
50
33
24
Parent Companies
Total Revenues
$0-$250
^$250-$1,000
.>$1,000-$10,000
>i$10,000
Number of
Companies
23
11
24
10
Source:  Section 308 Pharmaceutical Survey.
                                   3-27

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promotional costs are considered separately because of the critical role they play in realizing
long-term gains in the industry.
       3.2.3.7  Manufacturing Costs

       The most current data on costs of production in the pharmaceutical industry are available
from the Section 308 Pharmaceutical Survey. Table 3-10 presents cost data at the facility, owner
company, and parent company levels for the sampled entities. Costs are broken down into the
cost of pharmaceutical products and nonpharmaceutical products (including the cost of labor,
capital, materials, and overhead), total operating expenditures (e.g., energy, depreciation), and
research  and development.

       Product and operating costs rose from 1988 to 1990 in real  terms at all three levels.
Excluding research and development expenditures, the total cost of production at the facility
level rose from $7.4 billion in 1988 to $9.6 billion in 1990, from $58.7 billion to $63.8 billion at
the owner company level, and from $149.1 billion to $177.3 billion  at the parent company level.
The cost of pharmaceutical production as a percentage of the total cost of goods sold was
approximately  67 percent at the facility level, 33 percent at the owner company level, and 17
percent at the  parent company level in 1990.
       3.2.3.2 Research and Development

       The cost of researching, developing, and obtaining market approval for a new drug is a
significant component of total production costs. According to the U.S. Department of
Commerce, the pharmaceutical  industry spent approximately $11 billion in 1992 on R&D (U.S.
Department of Commerce, 1993). These expenditures amounted to more than 16 percent of
sales, one of the highest proportions for any U.S. industry. FDA estimates that 9 percent of all
U.S. industrial R&D is in Pharmaceuticals (FDA, 1990).
                                           3-28

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                                     TABLE 3-10

          COST OF PHARMACEUTICAL PRODUCTION IN SURVEYED POPULATION
                                   (Billions of 1990 $)
Production Cost Category
1988
Total
Average
1989
Total
Average
1990
Total
Average
Facility Level (n = 204)
Cost of pharmaceutical
products
Cost of nonpharmaceutical
products
Total cost of goods sold
$6.1
$13
$7.4
$0.03
$0.01
$0.04
$63
$3.1
$9.4
$0.03
$0.02
$0.05
$6.4
$32
$9.6
$0.03
$0.02
$0.05
Company Level (n = 98)
Cost of pharmaceutical
products
Cost of nonpharmaceutical
products
Total cost of goods sold
Total operating cost (not
including cost of goods)
Research and
development expenditures
$19.7
$39.0
$58.7
$35.6
$9.8
$02
$0.4
$0.6
$0.4
$0.1
$20.0
$43.0
$63.0
$40.0
$10.3
$02
$0.4
$0.6
$0.4
$0.1
$213
$42.5
$63.8
$40.0
$10.9
$0.2
$0.4
$0.7
$0.4
$0.1
Parent Company Level (n = 63)
Cost of pharmaceutical
products
Cost of nonpharmaceutical
products
Total cost of goods sold
Total operating cost (not
including cost of goods)
Research and
development expenditures
$253
$123.8
$149.1
$67.7
$14.3
$0.4
$2.0
$2.4
$1.1
$02
$27.6
$134.8
$162.4
$77.1
$15.6
$0.4
$2.1
$2.6
$12
$02
$29.7
$145.6
$177.3
$86.0
$17.4
$0.5
$23
$2.8
$1.4
$03
Source: Section 308 Pharmaceutical Survey.
                                          3-29

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       Section 308 survey data indicated a similar level of research and development
expenditures by the sampled owner and parent companies. Research and development cost data
were not available at the facility level. In 1990, research and development costs among the
surveyed firms amounted to $10.9 billion at the company level (an average of $100 million per
owner company) and $17.4 billion at the parent company level (an average of $300 million)  (see
Table 3-10). R&D costs averaged approximately 20 percent  of the cost of goods sold over the 3
years reported in both owner and parent companies. The reported expenditures include
nonpharmaceutical research and development expenditures  as well.

       The research  required to discover and develop NMEs is central to pharmaceutical R&D,
because manufacturers of generics and chemically similar  products build on the knowledge
produced in the course of developing NMEs. NMEs are discovered either through screening
existing .compounds or designing new molecules. Once synthesized, NMEs undergo rigorous
preclinical testing in laboratories  and in animals and then clinical testing in humans to establish
the compounds' safety and effectiveness. Further clinical studies might be conducted following
market approval.

       The primary component of R&D cost is labor. Pharmaceutical R&D draws on the
expertise of a diverse array of biological, chemical, and physical scientists to discover NMEs with
potential therapeutic benefits. Also of importance in pharmaceutical R&D is the opportunity cost
of capital, which can  be quite high given the risk and time involved. By some estimates, for every
9,999 compounds on which research is conducted, only one drug product is introduced to the
market. A typical pharmaceutical company will  require 9 to 12 years to bring an NME to market
(OTA, 1993).

       Tuft's Center for the Study of Drug Research,  a research institute specializing in the
pharmaceutical industry, recently estimated that it costs an average of $231 million ($1990) to
bring an NME to market. Approximately half of this total is the cost of capital (DiMasi, 1991).
In a recent study of the costs of pharmaceutical R&D, OTA estimated that the aftertax R&D
cash outlay for each NME that reached the market in the 1980s was about $65 million ($1990).
The full aftertax cost of these outlays, compounded over 12 years to the day of market approval
was approximately $194 million ($1990) (OTA, 1993). Moreover,  these costs include R&D
                                           3-30

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expenditures for unsuccessful as well as successful product development efforts. OTA points out
that the cost of pharmaceutical R&D is highly sensitive to changes in science and technology and
in the regulatory environment, both of which are continuously evolving. Consequently, the study
warns that one cannot predict future R&D costs from current estimates, which are based on
R&D costs for drugs that went into development more than 10 years ago. Some evidence exists
that pharmaceutical R&D is becoming more expensive over time as firms devote greater
resources to hiring scientists,  investing in new technology, and submitting their products to more
extensive preclinical and clinical testing.
       3.2.3.5 Marketing

       Promotional expenditures account for approximately 22 percent of the industry's revenues
(Day, 1993). Promotional expenditures tend to decline as a percentage of total sales over the life
of the drug. For example, OTA estimates that in the second year following market approval,
promotional expenditures account for 50 percent of sales. By the product's tenth year, however,
promotional expenditures will have declined  to only 6.5 percent of sales (OTA, 1993). Many view
these high promotional expenditures  as evidence that the industry does not compete on the basis
of price and instead devotes excessive resources to product differentiation through advertising.
Others contend that these promotional expenditures serve to educate physicians and allow new
competitors to enter specific drug markets (see Section 3.5.1).
       3.2.4  International Trade

       3.2.4.1 US. Department of Commerce Data

       The U.S. pharmaceutical  industry has consistently maintained a positive balance of trade
in international markets. In 1991, the industry's trade surplus totaled $961 million, and the U.S.
Department of Commerce estimates that it exceeded $1.3 billion in 1992. Exports totaled $5.7
billion in 1991 compared to $4.8  billion in imports. Nearly 47 percent of the industry's exports
were to the European Community in 1991. With $947 million in U.S. drug purchases, Japan
                                           3-31

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represented the greatest single-country importer of U.S. pharmaceuticals. On the import side, the
United States purchased $831 million in pharmaceuticals from the United Kingdom. Figure 3-7
show U.S. pharmaceutical exports and imports for 1991.

       The United States holds a dominant position in many international pharmaceutical
markets. In Europe, for example, U.S. pharmaceutical companies account for 25 percent of total
pharmaceutical sales. The United States also has a strong presence in Japan with 10 percent of
the market. Worldwide (including the United States), U.S. companies account for 33 percent of
total pharmaceutical sales (FDA, 1990). In important markets such as the United States, the
United Kingdom, and France, U.S. companies have introduced the largest percentage of new
drugs. Even in Japan, the United States is second only to Japan in new drug introductions.

       As in many U.S. industries, foreign investment in U.S. pharmaceutical companies
subsided in 1992 after peaking in the late 1980s. In 1990, foreign investment in U.S.
pharmaceutical companies totaled $10 billion, while U.S. investment in foreign pharmaceutical
companies totaled $10.6 billion.

       The U.S. Department of Commerce expects the United States to maintain its strong
position in international markets over the next decade. Nearly 33 percent of worldwide
pharmaceutical R&D is conducted by U.S. firms, thus providing the United States with a
competitive edge for developing new drug products. The North American Free Trade Agreement
(NAFTA), the advent of an economically unified Europe, and the increasing recognition of U.S.
patent laws in China, Mexico, and Latin America, all  suggest continued strength in  international
markets for the U.S. pharmaceutical industry. Greater political stability in the former Soviet
Union and other Eastern Block countries also will create new trading opportunities for the U.S.
pharmaceutical industry.
       3.2.4.2  Survey Data

       According to the Section 308 survey data, international sales account for a significant
proportion of the total revenues of surveyed facilities, owner companies, and parent companies.
                                           3-32

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This finding is not surprising given the multinational character of the pharmaceutical industry
(nearly 50 percent of the parent companies of surveyed facilities  are headquartered in foreign
countries). At the company level, international sales accounted for over 25 percent of all
pharmaceutical revenues generated in 1990. Nearly 50 percent of all pharmaceutical  sales made
by parent companies in 1990 were to foreign countries. International sales are an important
component of overall pharmaceutical sales at the facility level as well. Table 3-11 presents the
distribution of surveyed facilities by percentage of pharmaceutical shipments accounted for by
international sales. Although a substantial number (44 percent) of the surveyed facilities  reported
no international pharmaceutical sales, over 20 percent of the facilities reported receiving more
than 10 percent of their pharmaceutical  revenues from international sales in 1990. The mean
pharmaceutical export  rate for sample facilities was 8.8 percent in 1990.
       3.2.5  Financial Conditions

       The Section 308 Pharmaceutical Survey collected data on company costs, revenues,
liabilities, earnings, and other financial statistics. These data allow key financial ratios to be
calculated. The ratios are measures of a company's ability to meet short- and long-term
obligations and to generate a sufficient return  on investments. This section presents baseline data
on two financial ratios: (1) rate of return on assets (ROA), and (2) interest coverage or times
interest earned ratio. These  ratios will be used in Section Five to assess economic impacts at the
owner company level.

       Financial ratios are calculated at the owner company level only, where firm impacts  are
most direct and substantial. The ratios are also compared with industry benchmarks obtained
from Dun & Bradstreet Information Services. As explained in greater detail in Section 3.4,
baseline ratio data are used to identify firms whose financial condition, independent of regulatory
action, is sufficiently poor as to jeopardize their ability to make investments in wastewater
treatment systems. These firms are at risk of financial failure even without regulatory impacts.

       A variety of financial ratios are available for measuring the financial health of
pharmaceutical companies, including ratios addressing liquidity, asset management, debt

                                            3-34

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                                 TABLE 3-11

                  NUMBER OF FACILITIES BY PERCENTAGE OF
                   PHARMACEUTICAL SHIPMENTS EXPORTED
Percentage of
Pharmaceutical
Shipments Exported
0%
>0%-2.5%
>2.5-5%
>5%-10%
>10%
1989
Number
82
33
13
11
36
%
46.9%
18.9%
7.4%
63%
20.6%
1990
Number
77
36
13
10
39
%
44.0%
20.6%
7.4%
5.7%
22.3%
Note:  Only 175 facilities reported export data.

Source: Section 308 Pharmaceutical Survey.
                                     3-35

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management, profitability, and market value. The appropriate ratio choice depends on the
purpose of the analysis. This analysis focuses on measuring the possibility of facility closure or
firm financial failure because of regulatory impacts. To attract the financing for a wastewater
treatment system, a firm must demonstrate or project financial strength both before and after the
regulation-induced investment. Financial strength is often assessed on the basis of whether a firm
can incur debt associated with a capital investment while continuing to generate a return on
investment that will attract further investment. Thus measures of debt levels and profitability are
critical to the analysis of financial strength.

       The two ratios judged most important to the financial analysis of potential creditors and
investors are the rate of return  on assets and the interest coverage ratio. The sections below
define these ratios and discuss their value for this research. Additionally, the discussion reviews
the overall profitability of the industry, which helps to provide background for the remainder of
the financial analysis.
       3.2 J.I Return on Assets

       A firm's financial performance determines the willingness of creditors and investors to
provide the capital necessary to sustain or expand operations. If performance is poor, investors
will not provide capital or will seek higher returns in the form of higher interest rates on debt or
higher returns on equity to compensate for above-average levels of risks. The higher cost of
capital might in turn limit the ability of a given company to invest in  improved wastewater
treatment.

       Financial performance will be measured in terms of the pre-tax return on assets (ROA).
ROA is computed as the ratio of net income to assets:

                                            Net Income
                                            Total Assets
                                           3-36

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       ROA is a measure of profitability of a firm's capital assets, independent of the effects of
taxes and financial structure. It is perhaps the most comprehensive measure of a firm's financial
performance. ROA provides information about the quality of a firm's management, the
competitive position of a firm within its industry, and, on an aggregate level, the economic
condition of an industry overall. In addition, ROA incorporates information about a firm's
operating margin and asset management capability: the ratio of net income to sales (operating
margin), multiplied by the ratio of sales to assets (asset turnover), equals ROA. If a firm cannot
sustain a competitive ROA, it will probably have difficulty financing new investments. This is true
regardless of whether the financing is obtained through debt or equity financing.

       Table 3-12 presents baseline ROA data for companies included in the survey sample. The
ratio data are presented by quartile (i.e., with values given that denote the ratios for lowest 25
percent of firms, the median, and the highest 25 percent of firms) for firms grouped by annual
revenues. The mean and standard deviation for each group of firms also is presented.

       The return on assets over the years 1988 to 1990 varied from a first quartile of
approximately -3 percent to an upper quartile of 10 percent for the smallest size class of firms
(those with $25 million or less in annual revenues), to between 4 and 9 percent for the largest
firms (those with over $1 billion in revenues). The  data indicate that the lower quartile of firms
in the smallest size class, on average, generated negative net income between 1988 and 1990.
These firms appear to be the most vulnerable by the ROA measure. Long-term performance at
this level would threaten these firms' ability to stay in operation. All other ROA values given in
the table were positive.

     Table  3-13 presents industry ROA ratios reported by Dun & Bradstreet for each SIC of the
pharmaceutical industry. As can be seen, the results are more or less consistent with those drawn
from the survey sample. Dun & Bradstreet's  results reflect data for 266 companies overall. It
should be noted that differences in the organization of data makes the comparison of ratio
results only approximate.
                                           3-37

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                               TABLE 3-12

                  BASELINE RETURN ON ASSETS (ROA) AND
           INTEREST COVERAGE (ICR) RATIOS, BY ANNUAL REVENUES
Annual
Revenues
(Smillions)
Number
of
Observations
Mean
Lower
Quartile
Median
Upper
Quartile
ROA
0-25
26-200
201-1,000
> 1,000
60
55
33
26
-2%
5%
15%
7%
-3%
1%
2%
4%
5%
5%
7%
6%
10%
12%
26%
9%
ICR
0-25
26-200
201-1,000
> 1,000
60
55
33
26
Infinity
Infinity
Infinity
1,111%
-1%
201%
272%
372%
578%
464%
2,043%
677%
51,267%
8,470%
Infinity
1,130%
Source:  Section 308 Pharmaceutical Survey.
                                   3-38

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                                  TABLE 3-13

     COMPARISON OF SAMPLE RATIOS WITH PUBLISHED INDUSTRY AVERAGES

Source
Number of
Observations
Quartile

Lower

Median

Upper
ROA
Survey Sample (1988-1990
average)
Dun & Bradstreet Information
Services (1990)
SIC 2833
SIC 2834
SIC 2835
SIC 2836
174*


34
167
29
34
-3% to 4%


-2%
3%
NA
0%
5% to 7%


2%
10%
4%
4%
9% to 26%


11%
21%
7%
10%
ICR
Survey Sample (1988-1990
average)
Robert Morris Associates
(1991-1992)
SIC 2833
174*

113
-1% to
372%

180%
464% to
2,043%

440%
1,130% to
Infinity

1,110%
*Out of 177 firms, only 174 responded with data for computing ROA and ICR.

Sources:   Section 308 Pharmaceutical Survey data; Robert Morris Associates (1992); and Dun
         & Bradstreet Information Services (1993).
                                       3-39

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       3.25.2 Interest Coverage Ratio

       The second general area of concern to creditors and investors is the extent to which the
firm can be expected to manage its financial burdens without risk of financial failure. In
particular, if a firm's operating cash flow does not comfortably exceed its contractual payment
obligations (e.g., interest and lease obligations), the firm is vulnerable to a decline in profits or
an increase in costs because in either case its ability to continue meeting interest obligations
would be in jeopardy. Either scenario may (1) sharply reduce or eliminate returns to equity
owners of the firms, and/or (2) prevent the firm from meeting its contractual obligations.

       The ability to manage financial commitments  is expressed as the ratio of earnings before
interest and taxes (EBIT) to interest obligations, or the interest coverage ratio (ICR):

                                      KR-  EBTT
                                             Interest
A low ICR indicates vulnerability of the firm to financial failure and the potential for difficulty in
obtaining financing for wastewater treatment capital investments.

       As shown in Table 3-12, the interest coverage ratios vary from approximately -1 percent
to 51,267 percent for the smallest firms to 372 percent to 1,130 percent for the largest firms in
the Section 308 sample of firms. A number of firms reported no or negative interest burdens
over the specified time period. These firms were assigned ICRs of infinity. Only the lowest
quartile of companies in the smallest size class showed negative interest coverage ratios.

       Robert Morris Associates reported data on the interest coverage ratios for 113 firms. As
for ROA, these data are approximately consistent with those reported by the survey sample (see
Table 3-13). The median value in the Robert Morris sample is 440 percent. Median values for
the survey sample by size class ranged from 464 percent to 2,043 percent.
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       3.2.5.3 Overview of Profitability in the Pharmaceutical Industry

       This section presents additional evidence on profitability in the pharmaceutical industry.
If the pharmaceutical industry were found to be relatively unprofitable overall, then investment
levels in the industry would be declining and industry benchmarks might underestimate the extent
of vulnerability among industry firms.

       Profitability in the pharmaceutical industry has been extensively studied, and a recent
Office of Technology Assessment (OTA) research report, Pharmaceutical R&D: Costs, Risks and
Rewards, summarizes this work (OTA, 1993). OTA compared the pharmaceutical industry's rate
of return with that of other industries. OTA also considered whether the higher rates of return in
the  pharmaceutical  industry were caused by a higher cost of capital in the industry. Elements of
the  OTA research are summarized here.

       OTA compiled recent literature on the profitability and internal rates of return (IRR) for
the  pharmaceutical  industry. The IRR is the interest rate at which the net present value of all
cash flows into and out of the company equals zero. It provides a generally reliable method of
calculating the return on investments. OTA identified a  number of studies conducted  between
1975 and 1991 that  measured the profitability of the industry, including three studies that
compared the pharmaceutical industry to others. These studies were designed to improve on the
measurements possible  with publicly available reports of industry profits. Accounting measures of
profitability can be flawed because:
              Accounting standards require firms to record R&D, advertising, and promotion
              outlays as current expenditures, whereas they are generally investments with a
              future return. The value of the "intangible assets" represented by these
              expenditures is too uncertain for use in accounting statements but, nevertheless,
              represents assets that should be factored in.
              Financial statements report income and expenses as they are accrued and not
              necessarily as they are realized, which can distort the timing of revenues and
              investments and misrepresent the rate of return.
              Even if the other distortions are corrected, the accounting rate of return could
              still depart from the IRR because accounting profits do not adjust properly for
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             the time profile of cash flows from various investments and are further distorted
             by growth or decline in investment over time (OTA, 1993).
       The studies identified by OTA used various techniques to develop more accurate
estimates of the rate of return for the companies studied, such as incorporating information
about the timing of investments in R&D, correcting for the effect of inflation, incorporating
depreciation rates for investments in R&D and advertising, and other changes. The various
studies produced estimates of the IRR.

       Three studies compared the  corrected pharmaceutical industry IRR estimates with
similarly adjusted profit figures for other industries. The study results should be interpreted
cautiously because they covered very small samples of companies. Further, the studies tended to
focus on larger (and presumably more successful) firms. Nevertheless, the studies showed that
the adjusted rate of return for the pharmaceutical industry was found to be consistently higher
than that in the other industries examined.

       Table  3-14 summarizes the elements of the  most recent of the studies reviewed by OTA,
a study by Megan and Mueller of 10 pharmaceutical firms between 1975 and 1988. Megan and
Mueller compared the IRR for the pharmaceutical  industry with that of other industries that
have similarly large investments in R&D and advertising, including the toy, distilled beverages,
and cosmetics industries. These authors  used various assumptions about the depreciation of
R&D and advertising to measure the true profitability impact of these investments. This study
found that 10 pharmaceutical firms  had  an IRR of 12.15 percent. The other industries, with
similarly adjusted depreciation estimates, produced rates of return of 6.6 percent (toys), 11.44
percent (distilled beverages), and 11.5 percent (cosmetics).

       OTA also commissioned its  own report on the relative level of pharmaceutical industry
profits. This study, authored by Baber and Sok-Hyon, used a recently developed technique for
converting accounting data into an IRR estimate. This study compared rates of return for 54
research-intensive pharmaceutical firms with samples of companies in other industries. The
authors found that the pharmaceutical industry had IRRs that were consistently 2 to 3
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                                      TABLE 3-14

            SUMMARY OF PHARMACEUTICAL INDUSTRY PROFITS STUDY
  Study Description
Study Characteristics
Comment
  Pharmaceutical industry
  sample (Year of Data)
10 major firms, 1975 to 1988.
  Other industries sample
Selected firms in advertising or
R&D-intensive industries; 6 firms
in toy industry; 4 in distilled
beverage firms; 9 in cosmetic
firms.
Selected firms with similar
large investments in R&D
and advertising.
  R&D capitalization
  assumptions
R&D depreciation rates estimated
for each firm by regressing sales
on lagged R&D. Maximum 8-year
life for investment.
Capitalization rate
assumptions are necessary to
improve accuracy of rate of
return estimates over normal
accounting measures.
  Advertising
  capitalization
  assumptions
Same depreciation estimation
technique as for R&D with a
maximum 4-year life for
investment.
Capitalization rate
assumptions are necessary to
improve the accuracy of rate
of return estimates over
normal accounting measures.
  Rate-of-return
  estimates—
  pharmaceutical industry
12.15 percent
None
  Rate-of-return
  estimates—other firms
Toy industry - 6.66 percent
Distilled beverages -11.44 percent
Cosmetics -1131 percent
Other industries showed
lower rates of return, using
consistent adjustments to the
accounting data.
Source:  OTA, 1993.
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percentage points higher, under various alternative calculation methodologies, than those for
nonpharmaceutical companies.

       The question remains whether the observed differences in IRR resulted from differences
in the cost of capital. If pharmaceutical  investments are riskier, then investors would require
higher IRR and the cost of capital for the industry would be higher. OTA estimated the average
cost of capital for the industry and for two control groups. OTA found that the pharmaceutical
industry's cost of capital was slightly higher than that for one group of control firms  and lower
than that for another group.  OTA recognized the potential errors and biases in its measurement
techniques, but nevertheless  concluded that the higher rates of return  found for the
pharmaceutical industry could not be explained by differences in the relative costs of capital.

       Overall, the profitability of the pharmaceutical  industry appears to be above  average
among U.S. industries. This suggests that the overall baseline viability  of the industry is
equivalent to, if not better than, that of other industries.
3.3    INDUSTRY STRUCTURE AND THE PHARMACEUTICAL MARKET

       Information concerning market structure, the demand for Pharmaceuticals, and pricing
behavior provides much of the basis for reaching conclusions about the industry's ability to "pass
through" additional regulatory costs via higher drug prices and thereby predicting which entities
bear what portions of regulatory impacts. The first section of the following discussion (Section
3.3.1) examines evidence of market structure as  defined by barriers to entry, industry
concentration ratios, and vertical integration patterns. Market structure data must be
complemented by other information on the pharmaceutical industry as well. Subsequent sections
examine the characteristics of pharmaceutical  demand (Section 3.3.2) and market conduct and
performance (Section 3.3.3). Section 3.3.4 presents conclusions about the likelihood that
manufacturers can pass through regulatory costs to consumers of pharmaceuticals.
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       3.3.1 Market Structure

       The more barriers to entry that exist in a given market, the more likely it is that
monopolistic or oligopolistic conditions will prevail in that market. Such conditions allow firms
greater latitude in setting prices and hence the ability to pass regulatory costs along to
consumers. Barriers to entry and concomitant factors of concentration and vertical integration
are discussed in the following sections.
       3.3 J.1 Barriers to Entry

       Critics of the pharmaceutical industry often blame barriers to entry (i.e., economic, social,
and regulatory factors that prevent or discourage new firms from entering a given market) for
limiting competition in the pharmaceutical industry and thereby creating inefficiencies in the
supply of a socially desirable product. One major barrier to entry is the high cost of
pharmaceutical R&D. Raising the necessary capital to finance pharmaceutical R&D can be
difficult for new firms that have no capital resources of their own and must attract investors that
can tolerate long-term, high-risk investments. Investors might be more inclined to invest in
established firms that have demonstrated that they can bring a drug to market, recover R&D
expenditures, and produce reasonable returns on investment capital. Investors also might be wary
of new firms that have not demonstrated that they can clear FDA regulatory hurdles. For
example, new  firms might be less capable of producing well-documented and organized NDAs,
which can extend the regulatory review process and thus delay returns on investments.

    The prevalence of patents also serves to prevent new firms from entering particular drug
markets. By law, patented drugs in the United States enjoy ostensible protection from
bioequivalent drugs for a period of 17 years (OTA, 1993). This protection gives the drug
manufacturer a monopoly over its particular product for the life of the patent. Several factors,
however, act to reduce the effective patent life of drugs. The greatest threat to the effective
patent protection for a drug is the delay between patent issuance and FDA approval, which can
be as much as 10 years. Drug companies obtain patents during the R&D phase, and many years
can elapse before the company can take advantage of its monopoly power. OTA estimates that
                                            3-45

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the effective patent life (i.e., the time between drug approval and patent expiration) on new
drugs averages 11 years (OTA, 1993). Moreover, patents do not provide complete protection
from competition because competitors might be able to offer other drugs with similar therapeutic
benefits.

       Once patents expire, manufacturers of bioequivalent, or generic, drugs can enter the
market. Evidence suggests that over the past decade, introduction of generic versions of branded
products is becoming more common. Today, nearly 34 percent of all prescription drug orders  are
filled by generics rather than branded, or "pioneer" drugs, an 11 percent increase since 1986. As
noted earlier, the passage of the 1984 Price Act made it easier for generics to gain market
approval from FDA, and both public and private insurers have become  more adamant about the
use of less expensive generics.

       High promotional expenditures in the  pharmaceutical industry also can serve as a barrier
to entry. Traditionally, the economic literature has viewed high promotional expenses as an
indication of an imperfect competitive environment. In a market characterized by oligopoly (i.e.,
the domination of a given market by a small number of firms), firms will use advertising rather
than price competition to differentiate products. New firms  might be at a  disadvantage with
respect  to more established firms if they must compete on the basis of reputation rather than
price. The high promotional expenses required to compete in drug markets also add to the
capital demands on new entrants.

       Despite the high cost of promotion, several economists in the late 1970s determined
empirically that industry promotional expenditures were positively related to market entry. Thus,
new entrants use their promotional campaigns to achieve market entry. In a study of 17
therapeutic markets over the period 1969 to 1972, Tessler concluded that  promotional
expenditures actually facilitate  entry because new products could not compete with existing
products without being able to  distinguish  themselves through advertising. Hornbrook found
similar  results and concluded that promotional expenditures serve more as a market penetration
tool for new pharmaceutical manufacturers than as a barrier to entry (Feldstein, 1988).
                                          3-46

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       On balance, patent protection and long regulatory lead times for approval of new
Pharmaceuticals represent barriers to entry. Although it is extremely difficult to quantify the
impact of such barriers on market competition, it is likely that established pharmaceutical
companies have a degree of market power because of their regulatory experience, established
R&D operations, and patent protection. Although the number of pharmaceutical establishments,
particularly generics manufacturers, has grown over the past several decades, it is likely that
competition in the industry would have been greater in  the absence of high R&D costs, FDA
regulations, and other barriers to entry discussed above.
       3.3.1.2 Concentration and Vertical Integration

       The degree of concentration and vertical integration in a given industry is often used as
an indicator of barriers to entry. Concentration is generally measured in terms of the percentage
of value of shipments accounted for by a given number of firms in a particular industry. The U.S.
Department of Commerce calculated 4-, 8-, 20-, and 50-firm concentration ratios for all 4-digit
SIC industries through 1987 (see Table 3-15). The higher the concentration ratio in a given
industry, the easier it is for manufacturers to set prices or to collude to set prices. Industrial
economists have proposed that when the leading four firms control 40 percent or more of a given
market, the market may be characterized by oligopolistic conditions that present significant
barriers to entry.

       Table 3-15 lists the 4-, 8-, 20-, and 50-firm concentration ratios for SICs 2833, medicinal
and botanicals; 2834, pharmaceutical preparations; and 2836, biological products, as reported by
the U.S. Department of Commerce. As can  be seen, the four leading firms in SIC 2833
controlled 72 percent of sales of SIC 2833 products in  1987. This situation contrasts to the four-
firm concentration ratio of 22 percent in SIC 2834 and 45 percent  in SIC 2836. There are almost
three times as many companies  in SIC 2834 as in SIC 2833. The relatively low four-firm
concentration ratio of 22 percent in SIC 2834 and the relatively large number of companies
suggests that barriers to entry in the pharmaceutical  preparations sector of the industry are
relatively insignificant compared with barriers to entry in the medicinals and botanicals sector.
                                           3-47

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                                   TABLE 3-15

                 4-, 8-, 20-, and SO-FIRM CONCENTRATION RATIOS:
                        SICs 2833, 2834, AND 2836: 1954-1987
SIC Code
2833 Medidnals and
Botanicals
2834 Pharmaceutical
Preparations
2836 Biological
Products, Except
Diagnostics
Year
1987
1982
1977
1972
1970
1967
1966
1963
1958
1954
1987
1982
1977
1972
1970
1967
1966
1963
1958
1954
1987
Percent of Total Value of Shipments
4 Largest
Companies
72
62
65
59
64
74
70
68
64
72
22
26
24
26
26
24
24
22
27
25
45
8 Largest
Companies
80
75
78
75
74
81
81
79
77
84
36
42
43
44
43
40
41
38
45
44
65
20 Largest
Companies
89
85
89
90
NA
91
NA
91
89
93
65
69
73
75
NA
73
NA
72
73
68
80
50 Largest
Companies
95
94
96
98
NA
98
NA
99
98
NA
88
90
91
91
NA
90
NA
89
87
NA
93
NA = Not Available.

Source: U.S. Department of Commerce, 1991a.
                                       3-48

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       Nevertheless, concentration ratios calculated for such large industry segments are of
 limited value. The overall drug market is fragmented into a number of separate, noncompeting
 therapeutic markets. Manufacturers of antibiotics, for example, do not compete with
 manufacturers of muscle relaxants. Thus, concentration ratios should be calculated and analyzed
 within the specific therapeutic markets in which manufacturers  do compete. Only one study was
 identified in the economic literature of concentration ratios by therapeutic category. The study,
 conducted by Vernon (1971), divided the prescription drug market into 19 therapeutic markets
 according to the degree of demand-side substitutability between different drugs (i.e., relatively
 close drug substitutes were placed in the same general therapeutic market). The four-firm
 concentration ratios calculated by Vernon in the 19 therapeutic markets are presented in Table
 3-16. As can be seen, all of the concentration ratios are quite high; the lowest ratio in a
 therapeutic market is 46 percent. Several concentration ratios are in the 90 percent range, and
 the unweighted average is 68 percent. Vemon's study suggests that a relatively small number of
 companies dominate sales in the individual therapeutic markets.

       Even therapeutic market-specific concentration ratios might not present an accurate
 picture of competitive conditions in the pharmaceutical industry, however. According  to Feldstein
 (1988), concentration ratios are a static measure of market power. Feldstein notes that although
 a particular therapeutic market can be characterized by high concentration at a given  point in
 time, market  shares in that therapeutic market can change radically over time. Instability in
 market shares over time indicates intense competition among firms through new product
 innovation. One study in the early 1970s  noted that of the 20 industries investigated, only the
 petroleum industry possessed a higher degree of market instability than the pharmaceutical
 industry. Moreover, exit from and entry to the pharmaceutical industry seems to be quite high. In
 a study of 17 therapeutic markets between 1963  and 1972,15 markets had five or more new
 entrants. Market exit occurred in 16 of the 17 markets (Feldstein, 1988).

       A high level of vertical integration might also indicate the presence of barriers to entry in
 a given industry. Vertical integration refers to the extent to which production inputs and services
are produced and transferred within a given company, rather than procured from other
companies. In the pharmaceutical industry, a vertically integrated firm might  engage in research
and development, several stages of manufacturing (i.e., extraction and formulation), and
                                           3-49

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                         TABLE 3-16

CONCENTRATION RATIOS IN THE U.S. PRESCRIPTION DRUG INDUSTRY,
                BY THERAPEUTIC MARKET: 1968
Therapeutic Market
Anesthetics
Antiarthritics
Antibiotics-penicillin
Antispasmodics
Ataractics
Bronchial dilators
Cardiovascular hypertensives
Coronary-peripheral vasodilators
Diabetic therapy
Diuretics
Enzymes-digestants
Hematinic preparations
Sex hormones
Corticoids
Muscle relaxants
Psychostimulants
Sulfonamides
Thyroid therapy
Unweighted average
Four-Finn
Concentration Ratio
69
95
55
59
79
61
79
70
93
64
46
52
67
55
59
78
79
69
68
     Source: Vemon, 1971.
                              3-50

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distribution. In the pharmaceutical industry, the principal advantage of vertical integration is in
achieving economies of scope, which occur when production inputs can be used to produce
several different outputs. For example, cumulative drug R&D and promotional expenditures
might be used jointly in the production of more than one drug product. Economies of scope
might serve as a barrier to entry in the pharmaceutical industry to the extent that the high costs
associated with pharmaceutical R&D and promotion raise start-up costs and reduce the ability of
new firms to raise sufficient capital to profitably enter the industry.12

       Evidence from the Section 308 Pharmaceutical Survey provides some indication that
pharmaceutical companies are vertically integrated. Of the 139 parent companies for which
survey data are available, 129 have operations spanning all four of the industry's major
production processes: fermentation (process A), biological and natural extraction (process B),
chemical .synthesis (process C), and formulation (process D). Three of the parent companies own
facilities involved in processes A or C only, and 7 own facilities involved in processes B or D
only. At the facility level, 150 of the 244 facilities surveyed engage in only one production process
(101 of these firms engage only in formulation), 70 perform two production processes, 16
perform three production processes, and 8 engage in all four major production processes. Nearly
85 percent of the owner and parent companies reported R&D expenditures in the 3 years
surveyed.

     Thus, many pharmaceutical companies have chosen to integrate vertically. Companies that
engage in research and development, production of active ingredients, and formulation take
advantage of natural economies of scope that reduce the costs associated with developing and
marketing new drugs. The evidence indicates a degree of vertical integration in the industry. The
effect of this factor on market structure and market performance  cannot be quantified, but the
data suggest that major pharmaceutical companies have a degree  of market power.
    "Vertical integration also can lead to economies of scale where the existence of fixed factors
of production such as physical capital can cause unit costs to fall as output rises. It is generally
assumed,  however,  that  unit  costs are constant across output levels in the  pharmaceutical
industry.  Other  advantages  of vertical  integration might  include  the  ability  to  capture
monopoly/monopsony inefficiency loses  and engage in price discrimination (RTI, 1993).
                                           3-51

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       3.3.2 The Characteristics of Demand for Pharmaceuticals

       Demand conditions for pharmaceutical  manufacturers will help to determine the impact
of regulation-induced costs on market prices and outputs. This section examines various
characteristics of demand, including the market demographics, the primary market outlets, and
the effect of health insurance on the market.

       Demand conditions vary significantly among specific drug markets. Differences in
regulatory requirements and payment  mechanisms are particularly important in determining
demand. For example, in the prescription drug market (i.e., new drugs and generics), demand is
complicated by the role of health care providers and the presence of health insurance. Unlike
most consumer markets, consumers of prescription drugs are not directly involved in purchasing
decisions; that is, they do not decide which drugs to take, for how long, and at what  dosages.
Health care providers  act on the patient's behalf in deciding which medical treatment is most
appropriate given the patient's health  status, financial condition, and insurance coverage. These
topics are discussed further below.

       The demand for OTC (i.e., nonprescription) drugs,  on the other hand, conforms more
readily to standard models of consumer demand. OTC drugs are relatively easy to market,
available without physician consent, and sold in a relatively competitive environment. As for the
demand for other nondurables, the demand for OTC drugs is thought to be positively correlated
with income and negatively correlated with price. Consumers identify a specific health need, such
as relief from minor pain or cold symptoms, and then search for a product to satisfy that need.
Because in most cases a variety of OTC products will meet a given need, demand is heavily
influenced by advertising and price.
       332.1  Market Demographics

       Like the demand for health care generally, the demand for pharmaceuticals is derived
from the demand for good health. A pharmaceutical is both a consumption commodity, since it
makes the consumer feel better in the present, and an investment commodity, since it may
                                           3-52

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extend the life of the consumer. Given this view of pharmaceutical  demand, one would expect, all
other things being equal, that the demand for pharmaceuticals will  be dependent on factors such
as the incidence of illness and sociodemographic factors like age, education, and income. Other
factors such as perceptions of the seriousness of medical conditions and belief in the efficacy of
medical treatment also influence pharmaceutical demand.

       Among individuals, pharmaceutical  demand is heavily concentrated in the segment of the
population that includes people of age 65 and older.  In fact, today between 30 and 40 percent of
all pharmaceuticals are consumed by persons 65 years old and older (NatWest, 1992). This
finding is not surprising given the strong correlation between age and health. As the U.S.
population ages over the next several  decades, the demand for pharmaceuticals will presumably
rise. Since 1980, the number of people age  65 and older has increased at a rate more than twice
that of the general population.  By 1996, the U.S. Census Bureau predicts that 13 percent of the
U.S. population will be over 65 years of age. The U.S. Department  of Commerce cites the aging
of the U.S. population as one of the main reasons it  expects pharmaceutical sales to grow at
more than 5 percent annually over the next 5 years (U.S. Department of Commerce,  1993).
       3.32.2 Major Market Outlets

       According to a 1991 study of the pharmaceutical market, retail pharmacies and hospital
formularies (i.e., internal pharmacies) dispense over 84 percent of all pharmaceuticals sold in the
United States (see Figure 3-8). Direct mail order establishments and HMOs, however, are
capturing an increasing share of the market. Pharmaceutical purchases by hospitals have fallen by
6 percent since 1983. This drop is credited, in part, to changes in the Medicare system that have
created incentives for hospitals to reduce inpatient services. Drugs once prescribed on an
inpatient basis are now more likely to be prescribed on an outpatient basis and thus dispensed
through retail pharmacies (OTA, 1993).
                                           3-53

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       3.3.2.3 The Role of Health Insurance and Health Care Providers

       The demand for prescription drugs is influenced by the complex structure of health
insurance and health care provision. It is generally believed that the presence of health insurance
makes consumers relatively insensitive to the price of health care. Although not empirically
measured, this relationship is expected to apply to the demand for pharmaceuticals as well. The
full impact of health insurance on prescription demand is somewhat muted by deductibles and
copayments; nonetheless, health insurance almost certainly makes consumers less sensitive to
drug prices. Many privately insured Americans are protected from extraordinary medical costs
and, thus, have little incentive to limit health care expenditures, including the use of prescription
drugs. According to OTA, in 1987, 28 percent of all prescribed drug expenditures were paid for
by private insurance,  10 percent by Medicaid, 6 percent by other insurers such as Medicare and
Worker's. Compensation,  and 57 percent by individuals.13

       The percentage of Americans with public or private health insurance has risen steadily
over the past decade  to 86 percent today (OTA, 1993). Virtually all health insurance plans cover
hospital services, including prescription drugs administered at the  hospital. As noted earlier,
however, hospitals account for a declining share of total pharmaceutical sales in the United
States, dropping from 29  percent in 1983 to 23 percent in 1991 (OTA, 1993). This drop can be
attributed to a shift toward a greater reliance on outpatient services, which are often less
expensive than hospital care.

     Outpatient prescription drug insurance, although less common than inpatient coverage,
covers an increasing proportion of Americans. The proportion of outpatient prescription drug
purchases paid for by insurers increased from 27 to 43 percent between 1977 and 1987 (OTA,
1993). OTA estimates that in 1987, between 70 and 74 percent of the noninstitutionalized
population had at least some outpatient prescription drug coverage. Very few health insurance
plans cover 100 percent of prescription drug costs, however.  Full coverage is most common in
HMOs. Most health insurance plans rely on copayments to limit prescription drug use, although
    "Insurance coverage of pharmaceutical expenditures is less than that for health care generally.
Approximately 75 percent of all health care expenditures are paid for by insurance.
                                          3-55

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copayments are generally in the range of $5 or less (OTA, 1993). Private insurers generally cover
all drugs approved for market by FDA.14

       The lack of price sensitivity among consumers is partly offset by increasing sensitivity
among insurers. To control rising health care costs, many private and public insurers have moved
to limit pharmaceutical expenditures. Many private insurers have created incentives for physicians
and consumers to substitute generic drugs for branded drugs. OTA reports that in 1989,14
percent of all employer-based health insurance plans offered lower copayments for generic drugs
than for branded drugs. HMOs are particularly well suited to encourage generic drug utilization
because they control physicians more directly than fee-for-service plans. Some HMOs require
that their formularies automatically substitute generic drugs for branded drugs unless the
physician  explicitly instructs otherwise. HMOs and other insurers also try to reduce  drug costs by
negotiating with manufacturers for volume discounts and relying on direct mail-order pharmacies
for drugs  that patients need refilled on a regular basis. Medicaid, the nation's major public health
insurer, also creates  incentives to keep drug costs low.
       3.32.4 SubstitutabiUty among Pharmaceuticals and with Other Medical Services

       The availability of close substitutes plays an important role in determining competitive
conditions  in various drug markets. Generally, the greater the availability of close substitutes in a
given market, the more difficult it is to raise prices without losing market share. Substitution
occurs within specific drug markets or within the overall health care market (i.e., Pharmaceuticals
can substitute for other forms of health care), and both of these are discussed below.
    "Insurance does not always cover uses of prescription drugs not explicitly approved by FDA.
OTA reports that insurers are generally willing to reimburse for "off-label" uses that have been
documented as effective in one of three major medical compendia or in multiple published studies.
The so called off-label use of prescription drugs is common in many branches of medicine, especially
in the treatment of cancer (OTA, 1993).
                                            3-56

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        Substitutabillty among Pharmaceuticals

        The degree of substitutability within or across specific drug markets varies considerably
 among the patented drug market, the generic drug market, and the OTC drug market.

        Patented Drug Market. Patented drugs in the United States enjoy ostensible protection
 from bioequivalent drugs for a number of years. Effective patent life, however, reflects only the
 period of time in which a particular compound is formally protected from bioequivalent
 competitors. Manufacturers of patented drugs may enjoy market exclusivity for many years after
 patent expiration because of the time needed to approve generic competition, or because the
 particular market is too small to  entice generic competitors.15 In addition, manufacturers of
 patented drugs may be able to extend their monopoly power after patent expiration by
 developing new dosage forms for the same  drug. The 1984 Price Act automatically grants a
 3-year period of market exclusivity, regardless of patent status, to any drug for which an
 additional full NDA or NDA supplement has been submitted. With a new dosage form that
 makes a drug easier to administer or causes fewer side effects, the "pioneer" manufacturer can
 retain effective monopoly power because its competitors can only market the earlier, and
 presumably inferior, generation of the product.

     The availability of close substitutes for many patented drugs, however, erodes the monopoly
 power enjoyed by these manufacturers. Drugs of different molecular structure often can compete
 in the same therapeutic market. For example, calcium channel blockers, angiotensin-converting
 enzyme inhibitors, beta-blockers,  and diuretics all compete in the antihypertension  drug market.
 Between 1987 and 1992, 78 percent of the new drugs approved by FDA were deemed
 substantially equivalent to already marketed drugs in terms of medical  importance  and
 therapeutic usage (FDA, 1992). Thus, it would seem that although patents certainly reduce the
 availability of identical substitutes during the life of the patent, physicians in many cases can
 choose from more than one drug therapy to treat a given ailment.
   1SU.S. patent law prohibits companies from conducting commercially valuable research using
patented products.
                                          3-57

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       Generic Drug Market. The ascendancy of generic competitors in the prescription drug
market has greatly increased the availability of substitutes in the nonpatent drug market. Prior to
the 1984 Price Act, generics accounted for a low percentage of total prescriptions given their
relatively low price and FDA-guaranteed bioequivalence. Brand loyalty, strict FDA regulation,
and state antisubstitution laws that prevented pharmacies from making generic substitutions not
specifically requested by a physician all acted to reduce the ability of generics to compete with
branded prescriptions. Over the past decade, however, generic competition has increased
dramatically, and today generics account for 34 percent of all prescriptions written.

       The rise in generic competition is the result of several  factors. Perhaps most importantly,
both private and public insurers (i.e., Medicaid/Medicare) encourage, if not require, physicians to
prescribe generic drugs when  available (virtually all states have repealed their antisubstitution
laws). Many HMO formularies now automatically prescribe generic drugs unless the physician
makes a handwritten request  for a branded drug. As mentioned earlier, the 1984 Price Act made
it easier for generics to obtain FDA approval as well. In a recent study of 18 drugs whose patents
expired in 1983, Grabowski found that nearly all of the manufacturers lost about half of their
market share to generic competition within 2 years after initial entry of generic competitors
(Grabowski, 1992).

       OTC Market. As discussed earlier, the OTC market is much like other competitive
commodity markets where there is a high degree of substitutability and demand  is relatively
sensitive to changes in price. OTC drugs do not face the same regulatory hurdles as prescription
drugs and generally do not require such large R&D expenditures. Unlike many prescription drug
markets, most OTC drug markets are quite large and thus capable of sustaining  many
manufacturers of the same product.
       Substitutability with Other Medical Services

       Physicians typically can serve the patient in the hospital setting or they.can provide
ambulatory (i.e., outpatient) services, such as prescription medicines. For certain conditions,
Pharmaceuticals might be a very close substitute for inpatient services (e.g., hospitalization,
                                           3-58

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 surgery). For example, instead of performing surgery, a doctor might prescribe antibiotics to treat
 infected tonsils. Also, the use of vaccines reduces the prevalence of certain medical conditions
 such as polio, diptheria, and hepatitis. Some argue that pharmaceuticals can provide a relatively
 low-cost alternative to other available medical treatments. The Pharmaceutical Manufacturers
 Association (PMA) estimates that between 1976 and 1985 a new drug therapy for ulcers reduced
 the cost of treating ulcers by $5.8 billion (PMA, 1989).

       Nevertheless, pharmaceuticals are not a very close substitute for most other forms of
 medical treatments. Certain surgical procedures could be less expensive than drug therapy. For
 example, minor outpatient surgery at the onset of disease might be less costly than chronic drug
 treatment. Pharmaceuticals might, in fact, act more as complements to other forms of health care
 than as substitutes. Many surgical procedures are accompanied with pharmaceutical use both
 during and after surgery. Pharmaceuticals are used to diagnose certain diseases, which then might
 be treated through surgery or other medical procedure.

       Overall, the extent of substitutability is fairly low. Few pharmaceuticals can be replaced
 by nonpharmaceutical products and services, although more than one pharmaceutical product is
 often available to treat a given ailment. Nevertheless, substitutability is limited in the patented
 drug market where pharmaceutical products are protected from direct competition. The degree
 of substitution in the prescription drug market increases over time as patents expire and generic
 equivalents enter the market. Substitution is highest in the OTC market where market entry is
 relatively easy.
       3.333 Price Elasticity of Demand

       Few econometric studies have attempted to measure empirically the effect of price on the
demand for pharmaceuticals (i.e., the price elasticity of demand). Four such studies (Reekie,
1978; Lavers, 1989; O'Brien, 1989; and Johnston, 1991) have been published, although only one
was conducted in the United States. Their elasticity estimates are presented in Table 3-17, and
the results are discussed below.
                                           3-59

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                               TABLE 3-17




  ESTIMATES OF THE PRICE ELASTICITY OF DEMAND FOR PRESCRIPTION DRUGS
Study Author
Reekie (1978)
Lavers (1989)
O'Brien (1989)
Johnston
(1991)
Elasticity
Estimates
-1.03 to -2.83
-0.15 to -0.20
-0.23
-0.64
-0.5
Study Time
Frame
1958-1975
1971-1982
1969-1977
1978-1986
NA
Comments
Study of individual pharmaceutical
products within 25 therapeutically
competitive markets. Price of close
substitutes included in regression
estimate. Calculated separate estimates
for therapeutically significant and
insignificant drugs.
Study of increases in prescription charges
for a wide range of Pharmaceuticals in
the ILK.
Study of increases in prescription charges
for a wide of range of Pharmaceuticals in
the ILK.
Study of increases in prescription charges
for a wide range of Pharmaceuticals in
Australia.
NA = Not Available.
                                 3-60

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       In separate studies, O'Brien (1989) and Lavers (1989) estimated the effect on demand for
 a wide range of prescription drugs given an increase in the copayment demanded by Great
 Britain's National Health Service (NHS). Between 1969 and 1986 the charge for prescription
 drugs increased substantially in Great Britain from 0.125£ per prescription in 1969 to £2.20 in
 1986 (£1986), an increase in real terms by a factor of 17.6. The ratio of patient charges to actual
 drug cost also has more than doubled over that same time period from 0.21 in 1969 to 0.43 in
 1986. The patient charge is a fixed rate and does not vary by prescription  type. Men over the age
 of 65, women over the age of 60, children under 16, and low income groups are exempt from the
 prescription charges. Approximately 24 percent of the 323 million prescription items dispensed in
 1986 included an associated charge.

       Both O'Brien and Lavers found a negative relationship between prescription charges and
 the volume of nonexempt prescription  items dispensed. O'Brien's study estimated a price
 elasticity of demand over the entire period of -0.33, indicating that a 1 percent increase in patient
 charges leads to a 0.33 percent decrease in prescription drug use. O'Brien also discovered that
 there has been  a gradual change in time in the elasticity. For the period 1969 to 1977, O'Brien
 calculated a price elasticity  of -0.23. Elasticity increased in his study, however, to -0.64 between
 1978 and 1986.  This finding suggests that prescription drug use became more responsive to price
 between the study periods. Using similar data, Lavers found an elasticity of demand between
 -0.15 and -0.20  for the period 1971 to 1982, remarkably close to O'Brien's 1969-1978 estimate.

       Johnston (1991) studied a similar situation in Australia where federal policies led to  a
 doubling of prescription  charges for a large group of Pharmaceuticals in the 1970s. Johnston's
 estimate of -0.5 indicates slightly more elastic demand than indicated by studies conducted by
 O'Brien and Lavers.

       The studies conducted by O'Brien, Lavers, and Johnston do not consider the possibility of
 substitution among drug products within specific therapeutic markets, and thus do not provide a
complete measure of demand elasticity for individual drug products. Reekie (1978) accounts for
product substitution by including the price of therapeutically competing drugs in the estimating
 equations for individual prescription drugs within therapeutic categories. Using this method,
Reekie found more elastic demand  responses than either O'Brien, Lavers, or Johnston. Reekie's
                                          3-61

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estimates ranged from -1.03 to -2.83, depending on the therapeutic significance of the drug and
how many years the drug had been on the market. Predictably, Reekie's estimates were most
elastic for drugs that had been on the market for a number of years and offered only modest
therapeutic gains, and most inelastic for recently introduced drugs that provided important
therapeutic gains.

       Although these empirical studies are  hardly conclusive regarding price elasticity, they do
indicate that the demand for Pharmaceuticals as a group may be quite inelastic (i.e., between 0
and -1.0), whereas the demand for specific drug product may be relatively elastic (i.e., less than
-1.0). The  absence of close substitutes for drug therapies in general and the presence of health
insurance leads one to expect that the overall demand for Pharmaceuticals would be inelastic.
Conversely, given the existence of close substitutes for individual drugs (e.g., generics and other
therapeutically similar drugs) and the pressure  to control health care costs, the demand for
specific drugs may be relatively price elastic.
       3.3.3 Market Conduct and Performance

       To predict regulatory impacts, it is necessary to examine not only how the pharmaceutical
industry is structured, but how it behaves. The pharmaceutical industry has been under attack for
its seemingly uncompetitive pricing tactics, for having excessive market power related to patent
protection advantages, and for other potential barriers to entry discussed above. This section
explores the numerous factors  pharmaceutical manufacturers consider when setting drug prices,
examines the evidence on drug price inflation, and discusses some of the recent actions taken by
both industry and government  to control drug prices.

       A basic element of market performance  is the rate of price inflation. The price of drugs
has outpaced the rate of general inflation over the last several decades. Table 3-18 presents
producer price indices (PPI) for selected drug categories including all drugs, single-source drugs,
and multiple-source drugs for selected years between 1981 and 1988. As can be seen in the table,
the rate of increase in the PPI for almost all drug types outpaced inflation (i.e., the change in
PPI for all  commodities) in the seven years studied. Price inflation in the drug industry, however,
                                           3-62

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has not been as severe as for medical care generally. Table 3-19 lists consumer price indices
(CPI) for medical care generally, prescription drugs, hospital rooms, and physician services
between 1950 and 1985. According to this data, the CPI for drugs rose 187 percent between 1950
and 1985, in contrast to  the much larger CPI increases in medical care (651 percent) and hospital
rooms (2,245 percent) over the same time period. Interestingly, between 1950 and 1985, the CPI
for drugs rose less than the rate of inflation (i.e., the change in CPI for all goods and services).
In more recent years (i.e., between 1980 and 1985), however, the CPI for drugs increased twice
as much as the general rate of inflation.
       3.3.3.1 Patterns of Price Competition

       Manufacturers have considerable latitude to set prices according to factors other than
marginal cost, such as reputation, demand conditions in different markets (e.g., hospital v. retail),
and the company's long-run financial goals.16 Ultimately,  the prescription drug manufacturer
must establish a price that can recover the long-run costs associated with pharmaceutical research
and development. Typically, manufacturers of patented drugs will set initial price well above
marginal cost with the understanding that demand for  the product will most likely be fairly
inelastic at least until the patent expires and close substitutes become available. The
manufacturer uses the time between market  launch and patent expiration to recoup R&D costs
and generate sufficient profits to finance new product  development. The prescription drug
manufacturer will devote considerable resources to promoting its product during this period,
convincing physicians and patients of the drug's therapeutic benefits and establishing itself as the
preeminent supplier of the drug in anticipation of generic competition.

       Once the patent expires for a given prescription drug, price-competition becomes a
greater consideration. Because patented drugs will have garnered a certain level of brand loyalty
from physicians, generic drug manufacturers must enter the market with a relatively low price to
establish market share. According to NatWest Investment Banking Group, which monitors the
    "Evidence suggests that because of the wide availability of close substitutes in the OTC drug
market, OTC drug manufacturers generally act as price takers. It is assumed, therefore, that OTC
prices approximate marginal cost.
                                           3-64

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                               TABLE 3-19

         CHANGE IN CONSUMER PRICE INDEX FOR PHARMACEUTICALS
              AND SELECTED HEALTH CARE SERVICES: 1950-1985
Year
1950
1955
1960
1965
1970
1975
1980
1985
1950-1985
Percent Change from Previous Year
All Goods
and Services
(%)
NA
9.4
10.4
6.4
23.2
38.7
53.2
30.6
339.2
Prescription
Drugs
(%)
NA
9.7
13.5
-11.5
-0.8
8.0
41.6
71.5
186.7
Medical Care
(%)
NA
20.7
22.1
13.1
34.7
39.8
57.7
51.6
650.7
Hospital
(Semiprivate
Room)
(%)
NA
39.6
35.5
32.5
91.6
62.4
77.4
69.6
2,244.9
Physician
Services
(%)
NA
18.5
17.7
14.7
37.5
39.5
59.0
48.1
622.5
NA = Not Applicable

Source:  Feldstein, 1988.
                                   3-65

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generic industry, the first generic manufacturer to enter a given market generally prices its drug
around 30 percent below the brand-name drug and realizes a gross margin of about 55 percent.
The second generic manufacturer to enter a market usually prices its product at about a 40
percent discount, and the third entrant at about a 50 percent discount. NatWest estimates that by
the time the fourth generic manufacturer enters a market, generic prices are half of brandname
prices and gross margins will have fallen to 30 percent or less (NatWest, 1992). The advantage of
being the first generic entrant in a given market is clear.

       Contrary to expectations, manufacturers of branded drugs do not attempt to deter entry
into their markets by competing with generics on the basis of price. Rather, studies show that in
most cases pioneer firms continue to increase prices following entry  at the same rate as before
patent  expiration. Some industry experts believe that brand-name drug manufacturers do not
have the same force or the breadth of product line to compete with the major generic
manufacturers on the basis of price (NatWest, 1992). Branded manufacturers trust that despite
the relatively high price of their drug, physicians will continue to prescribe their drug over
generic drugs because they are familiar with it and because many question the quality of generic
drugs even though they have been deemed bioequivalent by FDA. Nonetheless, studies show that
branded drugs lose market share rapidly following patent expiration. According to  one study,
brand-name  drug market share declines to only 40 percent within 5 years following patent
expiration (Grabowski, 1992). Within 6 years, brand name drugs command only 20 percent of the
market. In its study of the industry, OTA made various market analyses using  an assumption that
within  10 years brand name drugs will have left the market altogether (OTA, 1993).
       3.3.3.2  Government Actions to Limit Pharmaceutical Price Increases

       In the last several years, industry as well as state and federal governments have taken
measures to control drug price inflation. For example, in 1990, 10 companies with over 40
percent of the U.S. pharmaceutical market share agreed to keep  drug prices in line with inflation
(Solomon, 1993). The PMA, which has spearheaded the effort, continues to enlist new companies
in the price control program. Today, 16 pharmaceutical companies in all have agreed to keep
increases in the price of their products at or below the rate of inflation.
                                          3-66

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       Federal and state governments have recently taken steps to control drug prices through
the Medicaid system. Medicaid provides health insurance for U.S. citizens of limited financial
means and is funded jointly by states and the federal government. Medicaid currently covers
outpatient prescriptions in 49 states and the District of Columbia, and accounts for nearly 15
percent of all outpatient prescription drug expenditures in the U.S. today (OTA, 1993). Retail
pharmacies dispense prescriptions at little or no cost to Medicaid recipients. State Medicaid
agencies then reimburse pharmacies according to specified price tables. Some 22 states require
copayments ranging between $0.50 and $3.00 per prescription  (OTA, 1993). States must cover all
drugs approved by the FDA.

       The 1990 Omnibus Budget Reconciliation Act (PL 101-508) altered state Medicaid
reimbursement policies. Prior to 1990, state Medicaid agencies reimbursed pharmacies according
to the pharmacy's acquisition cost plus a reasonable markup for single-source drugs, at no more
than 150 percent of the  lowest published price  for multiple-source drugs.17 In 1990, however,
Medicaid instituted a new reimbursement scheme whereby pharmaceutical  manufacturers must
give state Medicaid agencies a rebate on their drug purchases. The rebate is designed to  keep the
cost of Medicaid drugs at or below the rate of inflation. Beginning in 1994, Medicaid will
institute more stringent  reimbursement policies that will create strong  disincentives for
manufacturers to introduce drugs at above-average prices. The law will effectively reduce
revenues for manufacturers in the Medicaid segment of the pharmaceutical  market. The
mechanics of the new reimbursement policy are still being developed, and its effect on drug
prices is not yet known.  National health care reform could alter Medicaid drastically and might
include  its new incentives for controlling health care costs generally and drug costs in particular.

       The general trend toward cost-containment in the health care field could ultimately
increase the level of price competition in the prescription drug market. Thus, administrative
actions as well as consumer and market behavior combine to determine pricing patterns in  the
industry.
   "Single-source drugs are those available from only one manufacturer (i.e., a patented name-
brand drug). Multiple-source drugs are available from several manufacturers (i.e., generics).
                                           3-67

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       3.3.4 Conclusions about EIA Assumptions on Cost Passthrough Potential

       Because regulatory costs associated with effluent guideline limitations for the
pharmaceutical industry can affect a large portion of the industry, the industry as a whole might
be able to pass through regulatory costs to the consumer in the form of higher drug prices.
Individual companies (especially those marketing generic and OTC drugs), however, will have
less latitude to raise prices to the extent that their competitors do not face the same regulatory
costs. Nevertheless, many companies appear to have sufficient market power to pass through
regulatory costs.

       The price elasticity data also suggests that at least some of the regulatory costs can be
passed on to consumers. The price elasticity studies indicate that demand is highly inelastic in the
case of patented drugs with no substitutes (in the range of -0.2 to -0.4), mildly inelastic for
generic drugs (-0.6 to -0.8), and elastic for OTC drugs (less than -1.0). Thus, if the EIA
distinguished among these three market segments, regulation-induced price increases in each
component of  the industry could be examined. Unfortunately, product-specific cost  and price
data were not  available from the Section 308 Pharmaceutical Survey, and so the EIA can
examine impacts only on the drug market as a whole.

       Despite the evidence relating to market power and price elasticities, the EIA primarily
will use the conservative assumption that manufacturers cannot pass through compliance costs
except when impacts on consumers are investigated. In this latter case a 100 percent cost
passthrough assumption is used. The assumption of no cost passthrough maximizes the potential
regulatory impacts on manufacturers, whereas an assumption of 100 percent cost passthrough
maximizes the potential regulatory impacts on consumers.
3.4    REFERENCES

Day, Kathleen. 1993. Putting a Price on a Pill: Drug Firms Weigh New Intangibles in Setting
Costs. The Washington Post. March 21,1993.
                                          3-68

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 DiMasi, J.A., Hansen, R.W., Grabowski, H.G., et al. 1991. The Cost of Innovation in the
 Pharmaceutical Industry. Journal ofHeakh Economics 10:107-142.

 Dun & Bradstreet Information Services. 1993. Industry Norms and Key Business Ratios:
 Desk-Top Edition. New York: Dun & Bradstreet.

 Feldstein, Paul J. 1988. Health Care Economics. New York, NY: John Wiley & Sons.

 Grabowski. 1992. Brand Loyalty, Entry, and Price Competition in Pharmaceuticals After the 1984
 Drug Act. Journal of Law and Economics 35(2):331-35Q. October 1992.

 HCFA. 1992. Health Care Financing Administration. Pharmaceutical Price Changes: 1981-1988.
 Health Care Financing Review 14(1):90-105. Fall 1992.

 Johnston, 1991. As cited in RTI, 1993.

 Lavers, R J. 1989. Prescription Charges, the Demand for Prescriptions  and Morbidity. Applied
 Economics 21:1043-1052.

 NatWest. 1992. The  NatWest Investment Banking Group. The U.S. Generic Drug Industry. New
 York NatWest.

 O'Brien,  Bernie. 1989. The Effect of Patient Charges on the Utilization of Prescription
 Medicines. Journal of Health Economics 8:109-132.

 Reekie, Duncan W. 1978. Price and Quality Competition in the United States Drug Industry. The
Journal of Industrial Economics 26(3):223-237.

 Robert Morris Associates. 1992. Annual  Statement  Studies. Philadelphia, PA: Robert Morris
 Associates.

 RTI. 1993. Research Triangle Institute. Economic Analysis  of Effluent  Guidelines Regulations
 for the Pharmaceutical Industry. Draft Report. Contract No. 68-C8-0084. Research  Triangle
 Park, NC: RTI.

 Sherwood, Ted. 1993. U.S. Food and Drug Administration,  Center for Drug Evaluation, Office
 of Generic Drugs. Telephone conversation. May 19,1993.

 Solomon, Jolie. 1993. Drugs: Is the Price Right? Newsweek.  March 8,1993, pp. 38.

U.S. Congress, OTA. 1993.  Office of Technology Assessment. Pharmaceutical R&D: Costs,
Risks, and Rewards.  Washington, DC: U.S. Government Printing Office.

U.S. Department of Commerce. 1993. U.S. Industrial Outlook: 1993. Washington, DC: U.S.
Government Printing Office.

U.S. Department of Commerce. 1991a. U.S. Census of Manufactures: 1987. MC87I1A (CD-
ROM). Washington,  DC: U.S. Government Printing Office.

                                         3-69

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U.S. Department of Commerce. 1991b. Current Industrial Reports: Pharmaceutical Preparations,
Except Biologicals. MA28G(91)-1. Washington, DC: U.S. Government Printing Office.

U.S. Department of Commerce. 1990. County Business Patterns: 1990. Washington, DC: U.S.
Government Printing Office. Published in 1993.

U.S. EPA. 1992. U.S. Environmental Protection Agency. Pharmaceutical Manufacturing Industry:
Revision of Effluent Guidelines. Unpublished Status Briefing. Washington, DC: U.S. EPA.

U.S. EPA. 1991. U.S. Environmental Protection Agency. Guides to Pollution Prevention: The
Pharmaceutical Industry. EPA/625/7-91/017. Washington, DC: Office of Research and
Development, U.S. EPA.

U.S. EPA. 1983. U.S. Environmental Protection Agency. Development Document for Effluent
Guidelines, New Source Performance Standards, and Pretreatment Standards for the
Pharmaceutical Manufacturing Point Source Category. Washington, DC: U.S. EPA.

U.S. EPA. 1982. U.S. Environmental Protection Agency. Proposed Development Document for
Effluent-Limitations Guidelines and Standards for the Pharmaceutical Point Source Category.
Washington, DC: U.S. EPA.

U.S. FDA. 1992. U.S. Food and Drug Administration. Office of Drug Evaluation: Statistical
Report. Rockville, MD: U.S. FDA.

U.S. FDA. 1990. U.S. Food and Drug Administration, Office of Drug Evaluation. Overview of
the Competitiveness of the U.S. Pharmaceutical Industry. Presentation to the Council on
Competitiveness. Rockville, MD: U.S. FDA.

Vemon, John M. 1971. Concentration, Promotion, and Market Share Stability in the
Pharmaceutical Industry. Journal of Industrial Economics 19:246-266. July 1971.
                                         3-70

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                                  SECTION FOUR
               ECONOMIC IMPACT ANALYSIS METHODOLOGY
               OVERVIEW AND COMPLIANCE COST ANALYSIS
       The economic impact analysis (EIA) of effluent guidelines and standards for the
pharmaceutical industry covers several components necessary for identifying and characterizing
the potential impact of regulatory compliance costs at the facility and owner company levels, as
well as other secondary impacts.  The fundamental component of the methodology is the
facility-level analysis, which identifies facilities likely to  close because of incremental compliance
costs. This analysis is performed in Section Five.  Results of the facility analysis, combined with
additional firm-level and other data, provide the basis for determining the extent of secondary
impacts on owner companies (Section Six), employment (Section Seven), foreign trade (Section
Eight), small businesses (Section Nine), and specific demographic groups (Section Ten).

       Together, the impact analyses offer a comprehensive assessment of economic impacts at
all relevant levels of economic activity.  Figure 4-1 shows how the three principle individual
models (the cost annualization model, the facility closure model, and the owner company model)
relate to one another, the inputs required for these models, and the outputs they generate.  At
the heart of the EIA is the cost annualization model, which uses facility-specific cost data and
other inputs to determine the annualized capital and operating and maintenance (O&M) costs of
improved wastewater treatment. Annualized cost data feed into the facility analysis, which
investigates the economic impacts  on individual manufacturing facilities irrespective of ownership.
The company-level analysis examines the possible effects of increased regulatory costs and  facility
closures on companies that own one or more affected pharmaceutical establishments. The EIA
then explores the impact of facility and owner company closures on employment and other
measures of community welfare.   Additional analyses explore how increased compliance costs
will affect the balance of trade and whether small businesses and certain demographic groups will
experience disproportionate impacts.

       Ideally, the EIA methodology would include an analysis at the product-line level  of detail.
Higher compliance costs could be  expected to cause product-line closures at some facilities that

                                          4-1

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MODELS
                Discount Rate

                    Tax Rate

            Depreciation Factor

         Years of Equipment Life
                       Cost
                   Annualization
                      Model
                   (SECTION 4.2)
                                Annual Cost of Compliance Per Facility
   Cost of Production

   Value of Shipments

      -Salvage Value

   Earnings Forecast
                                       Owner
                                      Company
                                      Analysis
Facility Closure
  Analysis
                                                 ••*•—Assets
MODEL
OUTPUTS
                                                           Likely Owner-
                                                         Company Failures
                                                            and Other
                                                         Significant Impacts
Number of Facility
Closures (Baseline
   and Post-
  Compliance)
                                      Employment Impacts
                                         (SECTION 7)
                                                                              Total Annual Cost of
                                                                                 Compliance
                   Trade Impacts
                   (SECTION 8)
                                      Regulatory Flexibility
                                         (SECTION 9)
                                                          (SECTION 4.3)
                                      Distributional Impacts
                                        (SECTION 10)
            Figure 4-1. Interrelationship of HA methodology components.
                                         4-2

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remain in operation. An analysis of product-line closures, however, is not possible because the
Section 308 Pharmaceutical Survey did not collect financial information on individual product
lines. The facility closure and owner company-level analyses, however, are expected to be
adequate for evaluating impacts on this industry.

       The remainder of this section describes the cost annualization model (Section 4.1) and
employs the model to calculate the total annualized cost of compliance for the pharmaceutical
industry as a whole  (Section 4.2).
4.1    COST ANNUALIZATION MODEL

       4.1.1 Purpose of Cost Annualization

       The cost annualization model estimates the annual compliance cost to the facility of new
pollution control equipment and operation.  Cost annualization calculations consider the annual
cash outflow for the facility given the tax-reducing effects of expenditures (i.e., depreciation
allowances allowed on corporate income tax). The cost of additional pollution control
equipment can be divided between two components: the initial capital investment to purchase
and install the equipment, and the annual cost of operating and maintaining such equipment
(O&M costs).  Capital costs are a one-time expense incurred only at the beginning of the
equipment's life, and O&M costs are incurred every year of the equipment's operation.  The
engineering cost model used to estimate facility compliance cost defines both capital and O&M
costs.1

       To determine the  economic feasibility of upgrading a facility, the costs must be compared
against the facility's income statement and its capital structure. The initial  capital outlay should
not be compared against the facility's income in the first year because this capital cost is incurred
only  once. Additionally, it reflects the common practice of financing capital expenditures. This
   aCost data from Radian Corp.'s engineering cost model are reported for capital costs, O&M
costs, and energy costs. For simplicity, the cost annualization model treats energy costs as part
of O&M costs.

                                           4-3

-------
initial investment, therefore, should be spread out over the equipment's life. Annualizing costs is
a technique that allocates the capital investment over the lifetime of the equipment, incorporates
a cost-of-capital factor to address the costs associated with raising or borrowing money for the
investment, and includes annual O&M costs. The resulting annualized cost represents the
average annual payment that a given company will need to make to upgrade its facility.  The
annualized cost is analogous to a mortgage payment, which spreads the one-time investment in a
home into a series of constant monthly payments.
       4.1.2 Inputs and Assumptions

       4.12.1  The Regulatory Options

       The engineering cost estimates that feed into the cost annualization model are based on a
set of regulatory options developed by EPA. The following section summarizes these options.
The derivation of the initial engineering cost estimates under each option is discussed in the
Development Document (EPA, 1995).

       The pollution control options are divided into those for direct dischargers and those for
indirect dischargers.  Within each discharger category, additional distinctions are made.  First, all
technology options are divided between industry subcategories, with A and C industry
subcategories (representing facilities that use fermentation or biological and chemical synthesis
processes) being distinguished from B and D industry subcategories (representing facilities  that
use biological and natural extractive processes or that are formulators of pharmaceutical
products). For direct dischargers, the technologies are then further broken down into Best
Practicable Control Technology Currently Available (BPT), Best Conventional Pollutant Control
Technology (BCT), Best Available Technology Economically Achievable (BAT), and New Source
Performance Standards (NSPS) options; for indirect dischargers, Pretreatment Standards for
Existing Sources (PSES) and Pretreatment Standards for New Sources (PSNS) technology
options are examined.
                                            4-4

-------
       Table 4-1 presents the regulatory options addressed in this analysis and defines the
technologies associated with each option. The abbreviations used to briefly identify the options
(e.g., BAT-A/C#1, which represents the BAT control technology option 1 for the industry
subgroup consisting of facilities using the A and/or C production processes) are introduced in
this table. In all, there are 37 separate options, 21 for A/C facilities and 16 for B/D facilities.
None of these options is a zero-discharge option. Zero discharge options were eliminated
because EPA determined  that they were not technologically feasible.

       As Table 4-1 shows, five BPT options were evaluated for A/C facilities that are direct
effluent dischargers. BPT-A/C#1 consists of current biological treatment, while BPT-A/C#2 is
based on advanced biological treatment along with cyanide destruction.  BPT-A/C#3 includes the
same processes as BPT-A/C#2, plus effluent filtration.  BPT-A/C#4 also includes the same
processes as BPT-A/C#2, but adds a polishing pond. Finally, BPT-A/C#5 also includes BPT-
A/C#2 processes,  along with both effluent filtration and a polishing pond. Only three BPT
options are proposed for the direct discharging B/D facilities. BPT-B/D#1 consists of current
biological treatment, while BPT-B/D#2 entails advanced biological  treatment. BPT-B/D#3 adds
effluent filtration to the processes required for BPT-B/D#2.

       Three BCT options for A/C facilities and two BCT options for B/D facilities were
evaluated for direct dischargers.2  All of these options require advanced biological treatment. In
addition to the advanced biological treatment, BCT-A/C#1 adds effluent filtration and
BCT-A/C#2 adds  a polishing pond.  BCT-A/C#3 adds both effluent filtration and a polishing
pond to the use of advanced biological treatment.  BCT-B/D#1  requires only advanced biological
treatment, while BCT-A/C#2 adds effluent filtration to the advanced biological treatment.

       Four BAT options, which include advanced biological treatment as a minimum, were
evaluated for direct discharging A/C facilities. BAT-A/C#1 requires the use of advanced
        Development Document (U.S. EPA 1995) refers to these options as BCT-A/C #3, #4,
and #5 and BCT-B/D #2 and #3 because several less stringent BCT options (equivalent to BPT-
A/C #1 and #2 and BPT-B/D #1) here were considered before the preferred BPT option was
selected.  These options are not considered here because  they were equal to or less stringent
than the selected BPT options, thus are associated with no incremental costs. This document
does not address options that are not incremental to BPT.

                                          4-5

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                          TABLE 4-1




REGULATORY OPTIONS CONSIDERED IN THE ECONOMIC IMPACT ANALYSIS
Type of
Option
Name
Description
• Direct Dischargers
Best
Practicable
Technology
Best
Conventional
Technology*
Best Available
Technology
BPT-A/C#1
BPT-A/C#2
BPT-A/C#3
BPT-AO4
BPT-A/C35
BPT-B/D#1
BPT-B/D#2
BPT-B/D#3
BCT-A/C#1
BCT-A/C#2
BCT-A/C#3
BCT-B/D&1
BCT-B/D#2
BAT-A/C#1
BAT-A/C#2
BAT-A/C#3
BAT-AO4
BAT-B/D#1
BAT-B/D#2
Current biological treatment
Advanced biological treatment + cyanide destruction
Advanced biological treatment + cyanide destruction
filtration
Advanced biological treatment + cyanide destruction
pond
Advanced biological treatment + cyanide destruction
filtration + polishing pond
+ effluent
+ polishing
+ effluent
Current biological treatment
Advanced biological treatment
Advanced biological treatment + effluent filtration
Advanced biological treatment + effluent filtration
Advanced biological treatment + polishing pond
Advanced biological treatment + effluent filtration +
polishing pond
Advanced biological treatment
Advanced biological treatment + effluent filtration
Advanced biological treatment + cyanide destruction
nitrification where necessary
Advanced biological treatment + cyanide destruction
stripping
Advanced biological treatment + cyanide destruction
stripping/distillation
Advanced biological treatment + cyanide destruction
stripping/distillation + activated carbon
with
+ in-plant steam
+ in-plant steam
+ in-plant steam
Advanced biological treatment
Advanced biological treatment + in-plant steam stripping
                           4-6

-------
                                        TABLE 4-1 (cont)
Type of
Option
Best Available
Technology
(Cont.)
New Source
Performance
Standard
Name
BAT-B/D#3
BAT-B/DM
NSPS-A/C#1
NSPS-A/C32
NSPS-B/D#1
NSPS-B/D#2

Pretreatment
Standards for
Existing
Sources
Pretreatment
Standard for
New Sources
PSES-A/C#1
PSES-A/C#2
PSES-A/C#3
PSES-A/C#4
PSES-B/D#1
PSES-B/DS2
PSES-B/D#3
PSNS-A/C#1
PSNS-A/C#2
PSNS-A/C#3
PSNS-B/D#1
PSNS-B/DS2
Description
Advanced biological treatment + in-plant steam stripping/distillation
Advanced biological treatment + in-plant steam stripping/distillation
+ activated carbon
Advanced biological treatment + cyanide destruction + in-plant steam
stripping/distillation
Advanced biological treatment + cyanide destruction + in-plant steam
stripping/distillation + activated carbon
Advanced biological treatment + in-plant steam stripping/distillation
Advanced biological treatment + in-plant steam stripping/distillation
+ activated carbon
: ? ;r-'':-:':'-:Iaii^eeit IJEsctoaBceieisf'- ••>< ';:••' ''ft--- 4K:;-K&j;4y.' "*•-'. i,::^..:'.; "•'. . ' ;";
• ::. . -....;.. -. •;& -:.:.-- •-•••-•••••:-.-.;:••••:...- : • ••-..•• : • • . .
In-plant steam stripping + cyanide destruction
In-plant steam stripping/distillation + cyanide destruction
In-plant steam stripping/distillation + cyanide destruction + end-of-
pipe advanced biological treatment
In-plant steam stripping/distillation + cyanide destruction + end-of-
pipe advanced biological treatment + activated carbon
In-plant steam stripping
In-plant steam stripping/distillation
In-plant steam stripping/distillation + activated carbon
In-plant steam stripping/distillation + cyanide destruction
In-plant steam stripping/distillation + cyanide destruction + end-of-
pipe advanced biological treatment
In-plant steam stripping/distillation + cyanide destruction + end-of-
pipe advanced biological treatment + activated carbon
In-plant steam stripping/distillation
In-plant steam stripping/distillation + activated carbon
*In the Development Document (EPA,  1995), BCT-A/C#1, 2, and 3 in this table actually correspond to
Options 3, 4, and 5, and BCT-B/D#1 and 2 in this table correspond to #2 and #3. The options not listed in
this table were never considered in this report because they are equal to or less stringent than the requirements
of the selected BPT option, and thus no incremental costs are incurred over BPT.
                                             4-7

-------
 biological treatment, as well as cyanide destruction and nitrification where necessary. BAT-
 A/C#2 includes the same processes at BAT-A/C#1, along with in-plant steam stripping (both
 steam stripping and distillation control ammonia, however, so nitrification is not necessary).
 BAT-A/C#3 replaces steam stripping with in-plant steam stripping/distillation. BAT-A/C#4 adds
 activated carbon treatment to the processes required in BAT-A/C#3. Four BAT options based
 on the use of advanced biological treatment also were evaluated for direct discharging B/D
 facilities. BAT-B/D#1 involves the use of advanced biological treatment alone. BAT-B/D#2
 adds in-plant steam stripping to advanced biological treatment, BAT-B/D#3 replaces steam
 stripping with in-plant steam stripping/distillation. Finally, BAT-B/D#4 adds activated carbon
 treatment to BAT-B/D#3.

       Also for direct dischargers, two NSPS options that use advanced biological treatment at a
 minimum were evaluated for A/C facilities. NSPS-A/C#1 involves the use of cyanide destruction
 and in-plant steam stripping/distillation, along with advanced biological treatment. NSPS-A/C#2
 adds to this option activated carbon treatment.  Two NSPS options also were evaluated for B/D
 facilities. NSPS-B/D#1 involves the use of advanced biological treatment plus in-plant steam
 stripping/distillation.  NSPS-B/D#2 adds activated carbon treatment to this option. The selected
 NSPS options are discussed in Section Eleven, Impacts on New Sources.

       Four PSES options were evaluated for A/C facilities.  PSES-A/C#1 consists of the use of
 in-plant steam stripping and cyanide destruction.  PSES-A/C#2 consists of the use of in-plant
 steam stripping/distillation.  PSES-A/C#3 adds end-of-pipe advanced biological treatment to
 PSES-A/C#2. PSES-A/C#4 adds activated carbon to the processes required for PSES-A/C#3.
 For B/D facilities, three PSES options were evaluated. PSES-B/D#1 requires the use of in-plant
 steam stripping. PSES-B/D#2 requires the use of in-plant steam stripping/distillation, while
 PSES-B/D#3 consists of the use of activated carbon along with in-plant steam
 stripping/distillation.

       Three PSNS options were evaluated for A/C facilities that are indirect dischargers.
PSNS-A/C#1 involves the use of in-plant steam  stripping/distillation and cyanide destruction,
while PSNS-A/C#2 adds end-of-pipe advanced biological treatment to the processes required for
PSNS-A/C#1. PSNS-A/C#3 adds activated carbon treatment to PSNS-A/C#2. Two PSNS
                                          4-8

-------
 of in-plant steam stripping/distillation, while PSNS-B/D#2 consists of the use of both in-plant
 steam stripping/distillation and activated carbon. The selected PSNS options are evaluated in
 Section Eleven, Impacts on New Sources.


        Although all of these options are evaluated in the EIA, EPA has selected the following

 options for inclusion in the regulation:


        •      For direct discharging A/C facilities, BPT-A/C#2 is selected for conventional
               pollutants and BAT-A/C#2 is required for nonconventional pollutants.

        •      For direct discharging B/D facilities, BPT-B/D#2 is selected for conventional
               pollutants and BAT-B/D#1 is required for nonconventional pollutants.

        •      NSPS-A/C#1 is selected for new A/C facilities that are direct  dischargers (this
               option is identical to BAT-A/C#3).

        •      NSPS-B/D#1 is selected for new B/D facilities that are direct  dischargers (this
               option is identical to BAT-B/D#3).

        •      PSES-A/C#1 is  selected for A/C facilities that are indirect dischargers.

        •      PSES-B/D#1 is  selected for B/D facilities that are indirect dischargers.

        •      PSNS-A/C#1 is  selected for new A/C  facilities that are indirect dischargers (this
               option is identical to PSES-A/C#2).

        •       PSNS-B/D#1 is  selected for new B/D  facilities that are indirect dischargers (this
               option is identical to PSES-B/D#2).


As can be seen in Table 4-1, the selected BAT options include all of the processes mandated in
the selected BPT options.


       EPA also investigated an alternative regulatory scenario for existing sources and is
soliciting comments on this alternative.  The alternative regulatory scenario for existing sources
consist of BAT-A/C#3, BAT-B/D#1, PSES-A/C#2, and PSES-A/C#2.  Thus,  in this alternative

scenario (with the exception of BAT-B/D#1), in-plant steam  stripping is replaced by in-plant

steam stripping/distillation. The impacts of this alternative regulatory scenario (referred to as the

in-plant steam stripping/distillation scenario) are discussed briefly in comparison with the selected

regulatory scenario for existing  sources.
                                           4-9

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       4.12.2 The Cost Annualization Model

       Table 4-2 presents the cost annualization model using assumed data for illustrative
purposes. The inputs and assumptions for the analysis are listed above the spreadsheet. The
first input is the facility code for the facility analyzed.  The second line is the type of facility (e.g.,
A/C direct or B/D indirect). The third line presents the regulatory option or alternative for
which the annualized costs are calculated.3  The fourth and fifth lines are the option's capital and
O&M costs, developed by Radian Corp. (Development Document, EPA, 1995).  These costs are
provided in terms of 1990 dollars for comparison with 1990 survey data.

       The life of the asset is determined according to the Internal Revenue Code's classes of
depreciable property. Fifteen-year property is assumed to have a class life of 20 to 25 years—a
typical life span for the equipment considered in the costing analysis.  According to the U.S.
Master Tax Guide, 15-year property includes such assets as municipal wastewater treatment
plants  (page 311, Commerce Clearinghouse, Inc., 1991). Thus, for the purposes of calculating
depreciation, most components of the capital  cost for a pollution control option would be
considered 15-year property.

       The discount rate is used in calculating the present values of the cash flows. The discount
rate reflects pharmaceutical facilities' average cost of capital. The discount rate used in the EIA
is based on the discount rates reported by pharmaceutical facilities in the Section 308 Survey.
Reported discount rates of less than 4 percent and more  than 19 percent, however, were not
included in the discount rate calculation.  Discount rates  of less than 4 percent were thought to
be too low for inclusion in the calculation because banks  were charging a prime rate of nearly 11
percent and the Federal Reserve  Bank of New York had instituted a discount rate of nearly 7
percent during that time.  Similarly, discount  rates of more than  19 percent were considered to
represent a hurdle rate (the rate  of return desired for a project before it will be undertaken),
rather than a true discount rate.  Once these  discount rates were excluded, the mean and median
of the remaining discount rates reported in the survey were calculated. The mean was  11.4 and
    3The terms "option" and "alternative" are used interchangeably in this section.

                                            4-10

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-------
the median was 11.2.  This EIA uses the discount rate of 11.4 percent, which generates a slightly
more conservatively high estimate of annual costs.

       The final inputs to the model are the federal and average state tax: rates, which are used
in determining the facility's tax benefit or tax shield. A facility is allowed to offset taxable
income both with incremental O&M costs and with the depreciation of the equipment itself
(page 310, Commerce Clearinghouse, Inc., 1991).  These tax rates represent the marginal federal
tax rate (the rate applied to corporate income above $335,000)4 and the average state corporate
income tax rate (see Appendix A). A facility could be located in one state, while its corporate
headquarters is located in a second state and the corporation's holding company is located in a
third state. Given the uncertainty over which state tax rates apply to a given facility's revenues,
the average state tax rate is used in the cost annualization model.
       4.12.3 Annualizing Costs

       Two assumptions were made in annualizing compliance costs. The first assumption is
that the facility owners will be using the Modified Accelerated Cost Recovery System (MACRS)
to depreciate capital investments, which reduces the effective cost to the facility of purchasing
and operating the pollution control equipment.  The second is that a 1-year delay occurs between
the purchase of pollution control equipment and its operation. The details of these assumptions
and their impact on the results of the MACRS cost annualization model are presented in
Appendix A.

       In Table 4-2, the spreadsheet contains numbered columns that calculate the cost of the
investment to the facility.  The first column lists each year of the equipment's life span, from its
    The cost annualization model uses the 34-percent marginal federal income tax rate.
Adjustments to this rate could not be made to account for S corporations because the survey did
not identify corporate type.
                                           4-12

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installation through its 15-year depreciable lifetime.5  Column 2 represents the portion of capital
costs that can be written off or depreciated each year. These rates are based on MACRS as
derived in Appendix A.  Multiplying these rates times the capital  cost gives the annual amount
the facility can depreciate (Column 3). These amounts will be used to offset annual income.
Column 4 shows the tax benefit provided from the depreciation expense—the overall tax rate
times the depreciation amount for the year.

       Column 5 of Table 4-2 is the annual O&M expense.  These costs  are constant, except in
Year 1 when no O&M costs are incurred because the equipment is not yet in service.  Column 6
is the tax shield or benefit provided from expensing the O&M costs.  Column 7 lists the facility's
total expenses associated with the additional pollution control equipment.  It is assumed that
capital costs are incurred during the first year when the equipment is installed, and continue for
the life of the equipment. Added to this for all years except Year 1 is each year's O&M
expense. Column 8 lists the annual cash outflow minus the tax shields from the O&M expenses
and depreciation, because the facility will recoup these costs as a result of reduced income taxes.

       Once the yearly cost to the facility has been determined, it is  transformed into a constant
cost stream.  The bottom line in Column 8 represents the present value of the costs over the
equipment's life span.  The annualized cost is calculated as the 15-year annuity that has the same
present value as the bottom line in Column 8 of Table 4-2.  The annualized cost represents the
annual payment required to finance the cash flows after tax shields.  In essence, paying the
annualized cost every year and paying the amounts listed in Column  8 for each year are
equivalent. In this example, the capital investment of $614 thousand and annual O&M cost of
    5An asset's depreciable life can differ from its actual life. The pollution control equipment
considered in this analysis is in the 15-year property class; however, the actual life could extend
to 25 years. Under these circumstances, up to 10 years of O&M expenses would be excluded
from the present value calculations. The effect of excluding such costs, however, would not be
large, since in Year 16, a dollar is worth only $0.20 (assuming a 11.4 percent discount rate).
Furthermore, by adding more years to the calculation, the annualized cost is lowered, because,
even though O&M costs are incurred during the  extra years, payments  for the capital investment
will be spread over a longer time period.
                                           4-13

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$59 thousand (1990 $) result in an annualized cost of $101 thousand.6 Table 4-3 presents the
equations used to calculate present value and annual cost.

       The present value of the cost for incremental pollution control is used in the closure
analysis (Section Five).  The social cost of the regulation differs from the compliance cost.  The
social cost is the full value of resources used, ignoring tax shields, which affect only the
distribution of burdens between industry and government7.  The cost to society, therefore, is
always higher than the cost to industry. Results of the calculation of aggregate compliance costs
are presented below in Section 4.2.
4.2    TOTAL ANNUALIZED COMPLIANCE COSTS

       Total annualized compliance costs are calculated by aggregating the annualized
compliance costs for all affected facilities, based on the output of the cost annualization model.
Table 4-4 presents the results of this aggregation for A/C direct dischargers by category and by
option.  BPT-A/C#1 represents the baseline regulatory scenario. BPT-A/C#1 also is a proposed
option for this regulation and, consequently, has been evaluated as such in this EIA. Because
BPT-A/C#1 has already been implemented, however, it generates no economic impacts.  As the
table shows, the total posttax annualized costs for the 24 A/C direct discharge facilities,  excluding
the zero costs associated with BPT-A/C#1, range from $3.5 million for BCT-A/C#1 to $76.1
million for BAT-A/C#4.  Average costs per facility range from $0.1 million to $3.2 million per
year, depending on the option, not including BPT-A/C#1.
   6Note that the annualized cost can be determined in two ways.  The first way is to calculate
the annualized cost as the difference between the annuity value of the cash flows (Column 7) and
the tax shields (Columns 4 and 6).  The second way is to calculate the annuity value of the cash
flows after tax shields (Column 8).  Both methods yield the same value.
   7When social costs are derived, the appropriate discount rate is the social discount rate,
currently held to be 7 percent by OMB.

                                          4-14

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               TABLE 4-3

 PRESENT VALUE EQUATIONS USED IN THE
      COST ACTUALIZATION MODEL
   -  rritervori:
AMfUAUZED PASMm$T =
  tnf ~
  a  - term
                   4-15

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                                       TABLE 4-4
             COMPLIANCE COSTS FOR A/C DIRECT DISCHARGERS (1990 $)
Option
Number
Total
Capital Costs
Total
O&M Costs
Total Posttax
Annualized Costs
Average
Annual Cost
per Facility*
BPT Option Costs
BPT-A/C#1
BPT-A/C#2
BPT-A/C#3
BPT-A/C#4
BPT-AO5
$0
$14,742,689
$21,891,929
$37,455,760
$44,204,216
$0
$7,046,870
$7,488,423
$21,764,186
$23,420,779
$0
$5,681,474
$6,717,116
$16,665,409
$18,359,400
$0
$236,728
$279,880
$694,392
$764,975
BCT Option Costs
BCT-A/C#1
BCT-A/C#2
BCT-A/C#3
$16,875,845
$32,439,676
$39,188,132
$2,957,486
$16,545,942
$19,054,074
$3,551,327
$13,102,463
$15,288,512
$147,972
$545,936
$637,021
BAT Option Costs
BAT-A/C#1
BAT-A/C#2
BAT-AO3
BAT-AO4
$15,050,112
$56,392,127
$68,035,029
$92,851.663
$8,544,621
$35,689,088
$57,980,678
$114.229,651
$6,580,502
$26,779,144
$40,931,284
$76,143.696
$274,188
$1,115,798
$1,705,470
$3.172,654
*Total Posttax Annualized Costs divided by the total number of A/C direct discharge facilities.

Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report.

Source: ERG estimates based on Radian Corp. capital and operating costs estimates for pollution control
equipment
                                            4-16

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       Table 4-5 presents the same information for the 14 B/D direct dischargers.  Again, BPT-
 B/D#1 is the baseline, as well as a proposed option for this regulation.  Total posttax annualized
 costs, excluding the zero costs associated with BFT-B/D#1, range from $0.3 million to $2.9
 million, or about $23 thousand to $207 thousand per facility per year, depending on the option
 chosen.

       As discussed earlier in this section, all direct discharging facilities discharge both
 conventional and nonconventional pollutants and therefore must implement both BAT and BPT
 selected options.  The selected BAT options include all of the processes required in the selected
 BPT options.  Consequently, the results of the cost analysis for the selected BAT options
 (BAT-A/C#2 and BAT-B/D#1) represent the full costs (i.e., include BPT-A/C#2 and BPT-
 B/D#2) for all existing direct discharging facilities.

       Table 4-6 presents compliance costs for indirect dischargers, both A/C (88 facilities) and
 B/D (153  facilities). The total posttax annualized costs to all A/C facilities range  from $34.6
 million to $123.0 million per year, or $0.4 to $1.4 million per year per facility on average.  For
 the B/D facilities, the aggregate costs range from $7.9 to $63.5 million annually, at an average
 cost per facility per year of approximately $52 thousand to $415 thousand.

       Table 4-7 outlines the costs for the selected regulatory options. Total aggregate costs are
 approximately  $70.0 million per year, at an average annual cost per facility of approximately
 $0.25 million.  In comparison, under the alternative regulatory scenario (the in-plant steam
 stripping/distillation scenario), aggregate costs are $111.9 million per year at an average annual
 cost per facility of approximately $0.4 million.
4.3    REFERENCES

U.S. EPA. 1995. U.S. Environmental Protection Agency. Development Document.  Washington,
DC. February.
Commerce Clearinghouse, Inc. 1991.  U.S. Master Tax Guide.  Chicago, 1990.
                                           4-17

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                                         TABLE 4-5

              COMPLIANCE COSTS FOR B/D DIRECT DISCHARGERS (1990 S)
Option
Number
Total
Capital Costs
Total
O&M Costs
Total Posttax
Annualized Costs
Average
Annual Cost
per Facility*
BIT Option Costs
BPT-B/D#1
BPT-B/D#2
BPT-B/D#3
$0
$605,700
$2,976,515
$0
$519,349
$754^33
$0
$366,228
$760,837
$0
$26,159
$54,346|
BCT Option Costs
BCT-B/D#1
BCT-B/D#2
L_ $559,015
$2,929,830
$448,905
$683,889
$320,426
$715,035
$22,888
$51,074
BAT Option Costs
BAT-B/D#1
BAT-B/D#2
BAT-B/D#3
BAT-B/D#4
$644,446
$1,741,330
$3,002,607
$10,310,180
$1,104,801
$937,108
$1,950,161
$3,058,423
$708,758
$731,606
$1,454,688
$2,892,869
$50,626
$52,258
$103,906
$206,634
Total Posttax Annualized Costs divided by the total number of B/D direct discharge facilities.

Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report

Source: ERG estimates based on Radian Corp. capital and operating costs estimates for pollution control
equipment.
                                             4-18

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                                       TABLE 4-6

              COMPLIANCE COSTS FOR INDIRECT DISCHARGERS (1990 $)
                                         (PSES)
Option
Number
Total
Capital Costs
Total
O&M Costs
Total Posttax
Annualized Costs
Average
Annual Cost
per Facility*
A/C Facilities
PSES-A/C#1
PSES-A/C#2
PSES-A/C#3
PSES-A/C#4
$70,795,915
$90,082,486
$143,989,655
$186,990,945
$46,441,499
$81,860,584
$105,781,635
$177,615,256
$34,564,845
$57,137,102
$76,844,867
$123,048,025
$392,782
$649,285
$873,237
$1,398,273
B/D Facilities
PSES-B/D#1
PSES-B/D#2
PSES-B/D#3
$25,160,649
$30,429,899
$61.970,107
$8,956,179
$16,986,223
$98,119,347
$7,922,101
$13,137,467
$63,463,066
$51,778
$85,866
$414,791
*Total Posttax Annualized Costs divided by the total number of indirect discharge facilities.

Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report.

Source: ERG estimates based on Radian Corp. capital and operating costs estimates for pollution control
equipment.
                                         4-19

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                                       TABLE 4-7

         COMPLIANCE COSTS FOR SELECTED REGULATORY OPTIONS (1990 $)
Option
Number
BAT-A/C#2
BAT-B/D#1
PSES-A/C#1
PSES-B/D#1
Total
Capital Costs
$56,392,127
$644,446
$70,795,915
$25,160.649
Total
O&M Costs
$35,689,088
$1,104,801
$46,441,499
$8,956,179
Total Posttaz
Annualized Costs
$26,779,144
$708,758
$34,564,845
$7,922,101
Average
Annual Cost
per Facility*
$1,115,798
$50,626
$392,782
$51,778

Total**
$152,993,137
$92,191,568
$69.974,8481 $250,806
* Total Posttax Ammalized Costs divided by the total number of facilities for each subcategory.
** Total number of facilities includes seven nondischargbg facilities.

Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report

Source: ERG estimates based on Radian Corp. capital and operating costs estimates for pollution control
equipment
                                         4-20

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                                    SECTION FIVE
                    ANALYSIS OF FACILITY-LEVEL IMPACTS
       This section outlines the facility-level economic impact methodology and reports the
results of the analysis.  An overview of the methodology and how it relates to subsequent
analyses is discussed in Section Four.  The facility closure analysis takes output from the cost
annualization model to predict facility failures (see Section 5.1).  Section 5.2 summarizes the
number of baseline closures and additional  closures resulting from compliance with various BPT,
BCT, BAT and PSES control options.1  Conclusions of the facility-level analysis are presented in
Section 5.3.

       This section discusses the impacts on 282 facilities in the survey universe.2  Of these 282
facilities, 148 facilities are not directly considered by the facility closure model. These 148
facilities comprise two groups:  certifying facilities and single-facility firms.  These groups and the
reasons they are not directly considered by the model are described below.

       EPA exempted facilities from providing facility-level data if the company owners certified
that the regulation would have no impact on the facility. Sixty-five facilities (which represent 72
facilities in the survey universe) certified no economic impact on the facility (i.e., the rulemaking
will be economically achievable for the company and its certified facilities).  Another 76 facilities
in the survey universe indicated that their owner firm and the facility are the same entity (i.e.,
the firm owns only one facility). In these cases,  the firm-level analysis in Section Six was
determined to be the appropriate level at which to  evaluate impacts on these facilities. These 76
"firm/facilities," as well as the 72 certifying facilities, are placed automatically in the "no-closure"
category by the facility closure model. This approach avoids double counting of impacts at both
   Options for new sources are evaluated in Section Eleven. See Section Four for a description
of all regulatory options.
   2A total of 286 facilities are represented by 244 facilities in the Section 308 survey.  Four
survey facilities provided insufficient data in the Section 308 survey and are not included in this
analysis.
                                           5-1

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the firm and facility level.  Results of the analysis show impacts relative to all 282 facilities in the
analysis.
5.1    FACILITY CLOSURE MODEL

       Facility closures typically are estimated by comparing the facility's "salvage value" to the
present value of its future earnings.  The salvage value represents the expected amount of cash
the owner would receive if the facility were closed and liquidated.  The present value of earnings
represents the value in current dollars  of the expected stream of earnings that the facility can
generate over a specified period of time. If the salvage value is greater than what the facility is
expected to generate in earnings, then  it is assumed that the owner would liquidate the facility
and invest those resources in an investment with a higher expected return.3  This methodology,
however, is considered less realistic for facilities where firm and facility are the same entity.  It is
assumed that the firm-level analysis better reflects the decisionmaking at these establishments.
Thus, although all  facilities are analyzed here, the firm/facilities pass through the facility level
analysis unaffected and are analyzed in Section Six. Note that any firm failures among these
firm/facilities are distinguished from other types of firm failures in Section Six, and employment
losses are counted in Section Seven.

       Sections 5.1.1 and 5.12 describe the calculation of both sides of the closure equation (i.e.,
salvage value and the present value of future earnings).  Section 5.13 discusses how closures are
evaluated using the closure equation and Section  5.1.4 presents a closure calculation for a
hypothetical facility. Figure 5-1 provides a schematic diagram of the methodology and
components used in the closure analysis.
    3When a facility is liquidated for its salvage value, EPA assumes that the facility is no longer
operated; thus, closure-related impacts could result. In contrast, facilities that are sold because a
new owner presumably can generate a greater return are considered transfers. Transfers cause no
closure-related impacts, even if the transfer was prompted by increased regulatory costs.
                                            5-2

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Incremental Capital
 and O&M Costs
(from Engineering
  Cost Model)
    1
                  Net Income
I
                     Analysis of Recent
                      Industry Trends
Equipment Lifetime

  Discount Rate

Depreciation Rates

   Tax Rates
    i
       Discount Rate
Earnings
Forecast

rte


PRESENT VALUE OF
   FACILITY CASH
       FLOWS
         I
                                                Assessed Value
                                                   of Land,
                                                 Buildings, and
                                                  Equipment
                                                    t
                                                  Factor for
                                                Inventories and
                                                 Other Current
                                                   Assets
                                                    t
                                                Recovery Factor
                                                   i
                                                SALVAGE VALUE
                         A-B = (-)
                                                        CLOSURE
                         A-B =
                                                        NONCLOSURE
       Figure 5-1. Basic facility closure analysis methodology.
                             5-3

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       5.1.1  Salvage Value

       Salvage value is calculated assuming the pharmaceutical facility will be closed
permanently.  Thus, assets are evaluated based not on their potential for contributing to
operations, but only on their market value in a liquidation sale of land, buildings, equipment, and
inventories.  Salvage value is discussed assuming that all cash transactions are realized in the
current year and that discounting is not required.  In fact, many facilities could face multiyear
obligations that are not dismissed upon closure.  The salvage value is the net cash realized by the
plant owner after all assets are sold and obligations met.

       In theory, salvage value includes the value of current (i.e., short-term) assets and fixed
(i.e.,  long-term) assets.  Current assets, defined as those assets not expected to be held beyond
one year,, include cash, short-term Certificates of Deposit (CDs), inventory, and other assets.
Fixed assets include financial instruments expected to be held beyond a year and assets such as
of buildings, equipment, and land.

       Short-term assets held on balance sheets generally will be considered part of the facility's
working capital  and therefore are part of the facility's asset base.  Long-term financial assets,
such as deferred bond expense, stocks, bonds, and intangibles, might be held on the balance
sheet of either the facility or the owner company.

       The Section  308 Pharmaceutical Survey did not consistently collect data on current and
fixed assets at the facility level.   Typically, these data are held at the owner-company and parent-
company levels. Out of the 163 noncertified facilities surveyed, only 36 independently owned,
single-establishment companies reported facility-level data on fixed and current assets.  For
these 36 facilities, salvage value was calculated4 as the sum of total reported current assets and a
    'These data ultimately were not used directly in the facility closure analysis because of the
decision to evaluate firm/facilities in the firm-level analysis.
                                            5-4

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portion of fixed assets.5  For the remaining 127 facilities, other measures of fixed and current
assets were used to calculate salvage value as described below.
       5.1.1.1  Valuing Fixed Assets

       The model uses data on the assessed value of land, buildings, and equipment reported in
the Section 308 Survey to approximate the value of fixed assets for the 127 facilities not
reporting fixed assets.6  Assessed value of the facility is determined by local tax assessors.
Most facilities pay local property taxes based on the assessed value of the facility's fixed assets.
Nonetheless, a number of facilities  (33) failed to report assessed value in the survey. These
facilities might not have been assessed for tax purposes in recent years.

       A regression equation capable of modeling assessed value with a reasonable degree of
confidence could not be developed.  Although one might think that assessed value would be
somewhat related to the size of the plant  as measured by the number of employees and other
variables, in fact, assessed value may have more to do with local real estate conditions, politics,
and the competence of the local tax assessor. Rarely does assessed value correspond neatly to
actual market value, and market value itself is not easily predicted from size and other available
data.

       Given the inadequacy of regression analysis, a simpler approach was developed for
imputing assessed value.  In this approach, facilities with assessed value data (134 facilities) were
    5As explained below, a recovery factor of 20 percent is applied to reported fixed assets.
Current assets are valued at 100 percent.
    6Although assessed value is not a perfect approximation of fixed assets, it should be noted
that potential difficulties also arise when the book value of assets is used to estimate the salvage
value of a facility.  The book value understates the true value of some assets while overstating
the value of others.  For instance, a facility's land could have been purchased as long ago as the
19th century  and would have since appreciated in value tremendously. Other  assets, however,
might have no market value, but could continue to carry a book value because they have not yet
been completely depreciated.
                                            5-5

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divided into eight groups corresponding to manufacturing process (i.e., AC or BD) and
employment size (i.e., 1-18, 19-168,169-748, and >748) and then the median assessed value from
each of those groups was used to estimate assessed value for the 33 facilities not reporting these
data.  Table 5-1 shows the mean and median assessed values for each of the eight groups.  EPA
selected the median value.  It is the more robust estimator  (i.e., it is less sensitive to outliers than
the mean).

       This approach assumes that there is some relationship between assessed value and
employment size and production process. However, this relationship is assumed to be
nonparametric. Regression analysis requires parametric assumptions that  are unsupported by the
data.  The median value approach is simple, robust, and avoids parametric assumptions.
       5.1,1.2 Valuing Current Assets

       Current assets include cash and near-cash financial assets, accounts receivable, and
inventories.  The valuation of these assets is based on their probable value during an
auction/liquidation process. Because cash and near-cash financial instruments would not decline
in value in the event of liquidation, they command their face value even in a distress sale.
Accounts receivables and inventories (including both inventories of raw materials and finished
products)  are likely to decline in value to some degree depending on factors such as company
and industry experience with bad debt problems, economic conditions, and the geographic
proximity  of potential purchasers of raw materials or finished products.

       Current assets are carried in accounting statements based on their original purchase cost
or, in the  case of finished goods, on their manufacturing cost.  They are made up of two
components:  intangibles  (e.g., cash, receivables, and short-term investments) and inventories
(e.g., raw  materials, supplies, fuels, work-in-progress, and finished goods).

       Because most intangible current assets are quite liquid and do not decline in value when
liquidated, it is assumed they would be recovered at their face value.  Some items, such as CDs
and other short-term investments, could even appreciate in value compared to their cost as

                                           5-6

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                  TABLE 5-1

   ASSESSED VALUE BY EMPLOYMENT SIZE AND
             PROCESS CATEGORIES
Category
Sample
Size
Assessed Value
Mean
Median
Number of
Imputed
Values
A/C
1-18
19-168
169-748
>748
3
30
21
10
$644
$21,309
$50,915
$268,622
$811
$12,274
$28,228
$187,792
1
5
4
4
B/D
1-18
19-168
169-748
>748
5
24
30
11
$1,441
$7,355
$44,223
$90,645
$1,485
$4,215
$25,948
$72,843
3
4
8
4
Source: Section 308 Pharmaceutical Survey.
                       5-7

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recorded on the books because of accumulated interest.  Accounts receivable, however, could be
worth less than their book value, depending on each facility's accounting practices for recognizing
bad accounts.  Overall, the combined book value of these intangible current assets is likely to
approximate their actual market value (i.e., they are valued at 100 percent in the salvage value
calculations).

       Inventories are not as marketable as the rest of current assets because of their unique or
specialized purposes.  In the event of liquidation, a facility would have to sell its inventories at a
fraction of their recorded book value.  In anticipation of this, the survey asked  facilities to
report the value of inventories at cost or fair market value, whichever was lower. Thus, this EIA
will use the  value of inventories as reported.

       As noted above, current assets data were available for only 36 of the 163 noncertified
facilities.  Table 5-2 shows data on current assets and assessed value of land, buildings, and
equipment for 18 of these 36 facilities (assessed value data was unavailable for the other 18
facilities). As can be seen, inventories and other current assets tend to be as large as the
assessed value of land, buildings, and equipment for most of these facilities—the median ratio of
current assets to assessed value is approximately 100 percent.  The EIA uses this median current
assets to assessed value ratio for the 18 companies listed in Table 5-2 as a proxy for current
assets in the other 127 facilities.  Further refinement of the model is not possible given the small
sample.
       5.1.1.3 Salvage Value Calculation

       Once fixed assets were defined, either using direct survey data on assessed value, or by
extrapolation, a 20-percent recovery factor was applied to the facilities'  fixed assets. The
recovery factor is intended as an approximation of the percentage of fixed asset value recovered
in a liquidation. This figure has been used in previous Office of Water EIAs (see U.S. EPA,
1993) and is considered a conservative estimate allowing for very rapid  liquidation of assets.  One
hundred percent of the current  assets estimate, as discussed in Section 5.1.1.2, was then added to
the recoverable portion of fixed assets to compute an estimate of salvage value.

                                             5-8

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          TABLE 5-2

    CURRENT ASSETS AND
      ASSESSED VALUE
     (Thousands of 1990 $)
Number
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
Current Assets/
Assessed Value
of Land, Buildings,
and Equipment
4.0%
12.9%
31.2%
48.2%
84.1%
90.6%
93.0%
96.3%
10^3% *
118.6%
122.1%
124.5%
154.4%
179.8%
179.9%
196.5%
262.3%
266.8%
 ' Median value.
Source: Section 308 Pharmaceutical Survey.
                 5-9

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       Facility closure costs are not included in the salvage value estimates.  These costs reduce
the overall salvage value of the facility and are difficult to estimate even by facility executives.
These costs can include pension administration, payout costs, and site cleanup before sale.   As a
result of their omission, the calculated salvage value could be high, which would overstate the
likelihood of closure.  This approach provides a more conservative estimate (by biasing economic
impacts upward) of the potential facility closures.
       5.1.2  Present Value of Forecasted Earnings

       The present value of each facility is equal to its future stream of earnings in current
dollars. The valuation assumes that the facility continues to be used for the manufacture of
Pharmaceuticals.  The methodology uses recent earnings and other data to estimate future
earnings, and then applies discount rates to derive their present value.  The components of this
analysis include measuring earnings, establishing a time frame for the analysis, projecting
earnings, discounting earnings, and incorporating the incremental costs of regulation.

       Because of the number of assumptions that must be made in calculating salvage value
and because it is not always clear that a parent company would liquidate a "captive" facility,"
a salvage value approach might not be appropriate. A captive facility does not operate as a
profit center but transfers its products to the firm or another facility and values these shipments
at the cost of production. This arrangement might be common in a vertically integrated firm
structure. Appendix B presents a sensitivity analysis of facility closures based on salvage value
set equal to zero. Assuming a salvage value of zero is equivalent to assuming that a facility will
not close unless its present value of net income equals zero.  The sensitivity analysis (Appendix
B) shows that the closure analysis is not very sensitive to no or  lower salvage value assumptions.
Thus, the salvage value approach is considered an appropriate measure of facility-level impacts.
                                            5-10

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       5.12.1 Definition of Economic Earnings

        Two approaches typically are used to estimate the present value of future plant
operations:
              Net income, calculated as revenues less manufacturing cost of goods sold; selling,
              general, and administrative expenses; depreciation; interest; and taxes.
              Cash flow, which equals net income plus depreciation.
Estimates of the present value generated from future plant operations generally are based on
cash flow projections. Depreciation is added to net income because it reflects previous, rather
than current, spending and does not actually absorb any portion of incoming revenues.

       Net income figures also can be used to project the value of continued plant operations.
This approach assumes that ongoing reinvestment in plant and equipment will be necessary and
that in the long run, depreciation costs should be reflected as a charge against earnings (i.e.,
annual maintenance is not sufficient to ensure a facility's efficiency and capacity in the long run).
This approach, however, might overestimate potential closures in some newer facilities, which
would report higher depreciation figures and thus lower earnings.  Another factor that could
affect either net income or cash flow is inter-facility transfers of product among facilities owned
by the same firm. The Section 308 Pharmaceutical Survey asked respondents for their value of
shipments including transfers to other facilities owned by the same firm, but these transfers often
are valued at the cost of production, rather than at market value.  Net income or cash flow,
therefore, could be understated at these  facilities which could lead the closure model to overstate
total facility closures.

       In the closure model,  future earnings are based (to the extent possible) on net income
because it is a somewhat more conservative estimate of earnings than cash flow.  Reported net
income data is available for only the 36 independently owned facilities. For the remaining 127
facilities, the model approximates net income as the reported value of shipments minus the total
costs of production. The survey asked respondents to include depreciation of land and buildings
in the costs of production; depreciation of equipment is not specifically requested. If

                                           5-11

-------
depreciation is included by the respondent, value of shipments minus total costs of production
should approximate net income.  If depreciation of equipment is omitted from the costs of
production, the estimate will lie somewhere between net income and cash flow.
       5.12.2  Earnings Forecast

       The EIA uses a flat earnings forecast over the defined 16-year period (15 years plus 1
years of installation—see Section 4.1.2.2). In Table 5-3 one can see that, overall, net income
grew in real terms between 1988 and 1990 in the surveyed facilities.  In general, the surveyed
facilities experienced strong growth in net income in nearly all employment size categories
between 1988 and 1990. This growth rate is consistent with Commerce data that shows real
growth in shipments for the industry as a whole of 5 percent between 1988 and 1990.  Between
1988 and 1989, however, the surveyed facilities showed a small, real decline in net income. The
median growth rate between 1988 and 1989 was -0.2 percent, and a number of facilities showed
actual losses. Growth surged between 1989 and 1990, however, to more than make up for the
previous declines.

       Despite the earnings  dip in 1988-1989 among some facilities,  the flat earnings growth
projection is expected to be a reasonable, and possibly conservative, approach to estimating the
present value of future earnings for several reasons.  First, the pharmaceutical industry as a
whole is expected to grow in real terms at a modest rate over the next few years, barring the
institution of major price controls (see Section Three).7  In the longer term,  as the "baby boom"
generation ages, demand for Pharmaceuticals is likely to increase.

       Second, a large portion of the survey respondents showed appreciable real growth in net
income over the 3-year period captured by the survey. Among respondents for whom net income
    7It is beyond the scope of the EIA to predict major price shocks such as those possible with
the institution of comprehensive health system changes. It should be noted, however, that many
pharmaceutical firms have limited or are considering limiting price increases to the rate of
inflation (see Section Three). If this type of limit on price increases is proposed, the incremental
impact on earnings growth in the industry might not be as severe as would be expected without
the voluntary controls.
                                           5-12

-------
                        TABLE 5-3

        CHANGE IN NET INCOME BY EMPLOYMENT
                SIZE CATEGORY: 1988-1990
Employment
Size
0-19
20-99
100-499
500 - 750
>750
Number of
Facilities**
13
41
59
15
17
Change in Real Net Income*
Median
8.0%
-9.1%
4.4%
3.3%
6.4%
Range
Minimnm
-87.6%
-403.5%
-9589.0%
-60.4%
-7.1%
Maximum
1250.6%
374.4%
591.7%
120.0%
97.7%

All
145
5.3%
-9589.0%
1250.6%
* Six facilities had a change of infinity (i.e., net income in the base year was zero).
** Includes only those facilities with net income data for all three years.

Source: Section 308 Pharmaceutical Survey.
                           5-13

-------
could be calculated for all three years, real net income growth ranged up to 1,251 percent
between 1988 and 1990, with a median real growth rate of approximately 5.2 percent.8

       Finally, using an assumption of declining earnings at some facilities could lead to more
facilities closing under the baseline scenario, potentially understating the impacts of the
regulation. This would occur if, in fact, the declines seen in 1988-1990 are not transitory.
Although an assumption of flat earnings over the time period of the analysis might understate
baseline closures for some facilities, it is unlikely that all facilities showing a decline in the 1988-
1990 period would continue to decline over the analysis timeframe.  Thus the general trends
predicted for the industry as a whole are considered a more accurate predictor of earnings
growth over the next 16 years than the 3-year history at any one facility.

       Several reasons lead to the rejection of a rising earnings projection. First, the facilities
might be running at or near full capacity and  significant growth would not be possible without
making major capital investments in buildings and production equipment.  Second,  for many
facilities, a flat earnings projection is quite conservative, leading to a conservative assessment of
postcompliance closures.

       In addition to flat earnings growth, The model employs several other assumptions and
procedures as well:
              Zero cost passthrough.  The facility is assumed to be unable to raise prices to
              recoup incremental pollution control costs.  It is as if there is a supply of foreign-
              made Pharmaceuticals waiting at the U.S. border; if domestic facilities raise their
              prices, imports will flood into the domestic market.  As discussed in Section
              Three, this assumption might not be realistic given that many firms act as price
              setters in certain drug markets. This assumption, therefore, is extremely
              conservative.9
    8Nineteen of the 163 respondents did not report sufficient data to calculate the change in net
income between 1988 and 1990. These 19 respondents were removed from the sample prior to
calculating the median net income growth rate.
    "Because impacts were found to be so small, alternative assumptions on cost passthrough
were not investigated (see Section 5.2).
                                           5-14

-------
              Constant 1990 dollars. Data from 1988 and 1989 are inflated using the change in
              the Consumer Price Index for SIC 283.
              Discounting. Net income is discounted over a 16-year period, since, as explained
              in Section 5.1.1, the capital expenditures associated with additional pollution
              control for the pharmaceutical industry are depreciated over a 15-year lifetime
              plus a 1-year construction period. The same cost of capital factor used in the cost
              annualization model is also used to discount earnings. This factor takes into
              account the rate of inflation.
       5.1.3  Evaluating Closures

       The model evaluates closure on a facility-specific basis. As discussed above, salvage value
and net income are estimated for each facility. In the baseline analysis, the basic model
calculates the present value of the earnings stream (using the 3-year average net income from the
survey) over the 16-year time frame and subtracts that present value from the calculated salvage
value.  If salvage value exceeds the present value of net income, the model classifies the facility
as a "closure" in the baseline. These "closure" facilities are eliminated from the subsequent
postcompliance closure  analysis, as a real-life closure under this scenario could not be attributed
to the regulation. Note that all facilities whose 3-year average net income is negative are
assumed to close in the  baseline.

       For postcompliance closure analysis, the model uses the facility-specific annualized costs
for each BPT, BCT, BAT, and PSES option to  calculate declines in net income. Annualized
compliance costs are subtracted from the present value of net income to arrive at the present
value of postcompliance net income.  Salvage value minus the present value of postcompliance
net income is then calculated, and, again, where the salvage value exceeds the present value of
net income, the model classifies the facility as a closure.  The number of estimated closures
under each regulatory scenario  is recorded by employment size and option.
                                           5-15

-------
       5.1.4  Sample Closure Analysis

       Figure 5-2 presents an example of the calculations undertaken to determine closure.  The
salvage value net income and compliance costs of a hypothetical facility are used to calculate
whether closure is likely to occur. As can be seen in this case, this facility is projected to remain
open in the baseline and postcompliance analyses.
5.2    RESULTS

       5.2.1  Baseline Closures

       The analysis indicates that 38 facilities, or 13 percent of the total, will close in the
baseline. The highest number of closures occurs in the B/D indirect  discharge facilities
employing  19-167 employees.  In this group, 12 facilities, or 23 percent of the total number of
facilities in this group, are estimated to close in the baseline (see Table 5-4). Nearly all the
closures occur among indirect dischargers (36 of the 38 facilities estimated to close are indirect
discharging facilities), and the highest number of these closures occur among the facilities
employing  19 to 167 employees.  (As noted earlier,  total facilities include firm/facilities, but these
establishments are analyzed in Section Six.)
       5.2.2  Postcompliance Closures

       Tables 5-5 through 5-7 present estimates of postcompliance facility closures by type of
discharger (A/C direct dischargers, B/D direct dischargers, and indirect dischargers) by each
option under consideration for each group. As shown in Table 5-5, one A/C direct discharging
facility closes (in the 1-18 employees size category) under the most stringent option,
BAT-A/C#4.  No other regulatory options considered for A/C direct dischargers are expected to
result in closures of A/C direct discharging facilities. Table 5-6 presents the analysis for B/D
direct dischargers.  No B/D direct facilities are predicted to close as a result of any of the
proposed regulatory options. Table 5-7 presents results for indirect dischargers. A B/D indirect

                                            5-16

-------
FACILITY NO. 0001

Key parameters (Smillions)

       Estimated salvage value (ESV):
       Present value of net income (PVNI):
       Annualized cost of compliance (ACC):      -
       Present value of annualized compliance cost (PVAC):
                 $  1.33
                 $ 14.23
                 $  0.45
                 $  4.29
Sample Calculation
             Baseline Calculation
        Postcompliance Calculatiori
         14.23 (PVNI) > 1.33 (ESV)
                 No Closure
[14.23 (PVNI) - 4.29 (PVAC)] > 1.33 (ESV)
               No Closure
                      Figure 5-2.  Sample Facility Closure Calculation.
                                         5-17

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facility (employing 19-167 employees) is expected to close under PSES-B/D#3. No other
closures are expected under any other options for indirect dischargers.  Thus closures occur only
under the most stringent options considered, and only A/C direct and B/D indirect dischargers
will experience significant impacts under these options.

       As discussed in Section Four, the following options have been selected by EPA:
BPT-A/C#2, BPT-B/D#2, BAT-A/C#2, BAT-B/D#1, NSPS-A/C#1, NSPS-B/D#2,
PSES-A/C#1, PSES-B/D#1, PSNS-A/C#1, and PSNS-B/D#1. (NSPS and PSNS options are
discussed in Section Eleven.)  As discussed in Section 4.2, the cost impacts of the selected BAT
options (BAT-A/C#2 and BAT-B/D/#1) also cover the cost impacts of the other BPT and BCT
selected options for direct dischargers. Thus the impacts of BAT-A/C#2, BAT-B/D#1, PSES-
A/C#1, and PSES-B/D#1 are evaluated as the selected regulatory options.  As Table 5-8 shows,
no facility closures are  expected to occur as a result of the selected regulatory options (see
Section Six for a discussion of any impacts on firm/facilities).  Additionally, no facility closures
are expected to occur as a result of the alternative regulatory scenario (the in-plant steam
stripping distillation scenario; see Appendix C).
5.3     REFERENCES
U.S. EPA. 1993. Economic Impact and Regulatory Flexibility Analysis of Proposed Effluent
Guidelines and NESHAP for the Pulp, Paper, and Paperboard Industry. Office of Water,
November.
                                         5-22

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                                     SECTION SIX
                       ANALYSIS OF FIRM-LEVEL IMPACTS
       The firm-level analysis evaluates the effects of regulatory compliance on firms owning one
 or more affected pharmaceutical facilities.  It also serves to identify impacts not captured in the
 facility analysis.  For example, some companies might be too weak financially to undertake the
 investment in the required effluent treatment, even though the investment might seem financially
 feasible at the facility level.  Such circumstances can exist at companies owning more than one
 facility subject to regulation.  Given the range of possible firm-level responses, the firm-level
 analysis is an important component of the EIA.

       Parent company (i.e., the owner of the owner company) impacts are not analyzed. As
 one progresses up  the corporate hierarchy and assets increase, the impacts of a given facility
 closure or major facility-level capital investment become more dilute.  For the 63 single
 establishment firms in the survey universe (the firm/facilities), however, analysis at the facility
 level, firm level, and corporate parent level coincide. As noted in Section Five, analysis of these
 firm/facilities was deferred to the firm-level analysis.1

       The  firm-level analysis summarized in Section 6.1 assesses the impacts of facility closures
 on each firm and the impact of compliance costs at all facilities owned by the firm that do not
 close.  These impacts are assessed using ratio analysis, which employs two indicators of financial
 viability:  the rate of return on assets (ROA) and the interest coverage  ratio (ICR).  Results and
 conclusions  of the firm-level analysis are presented in Sections 6.2 and 6.3.
    'The total number of firms discussed in this section is 187.  Three firms provided insufficient data
and thus were not analyzed and are not included in this count. Included hi the 187 firms are 38 firms
that certified all their facilities as not incurring impacts from the regulation. However, since two of
these certified provided financial data, they were analyzed in the firm failure model. Thus, a total of
36 certifiers are excluded from some of the analyses.
                                           6-1

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6.1    RATIO ANALYSIS METHODOLOGY

       The ratio analysis is conducted from the perspective of creditors and equity investors who
would be the source of capital to finance a company's treatment system investment. To attract
financing for a treatment system, a company must demonstrate financial strength both before
and, on a projected basis, after the treatment system has been purchased and installed.  The ratio
analysis simulates the analysis an investor and or creditor would employ in deciding whether to
finance a treatment system, or make any other investment in the firm.

       A baseline ratio analysis evaluates the company's financial viability before the investment,
and a postcompliance analysis predicts the company's financial condition subsequent to the
investment. The baseline analysis identifies companies whose financial condition, independent of
pending regulatory actions, is extremely weak. Such companies are at risk of financial failure
even without the additional cost of the regulation.  Before the baseline firm-level analysis is
undertaken, baseline  facility closures are accounted for, since these closures affect baseline net
income, earnings, and assets.  Firms that are projected to fail in the baseline analysis are
excluded from the postcompliance analysis.  The postcompliance analysis identifies those
companies, otherwise financially sound, whose financial viability is threatened by regulatory
compliance.  Such companies would be weakened by the burden of financing wastewater
treatment  equipment purchases and operating and maintaining the system. These companies are
characterized as significantly affected by the revised effluent standards.

       The postcompliance analysis has two components.  The first component uses the results
of the facility closure analysis to identify losses in net income and earnings before interest and
taxes  (EBIT), and assets stemming from a facility closure (baseline impacts from closures are
accounted for in the baseline analysis and are carried forward into the postcompliance analysis).
The next component  uses the annualized compliance costs from all facilities that are projected to
remain open to identify their losses of net income and EBIT.  The postcompliance net income
                                           6-2

-------
and EBIT reflecting facility closures and higher production costs is then used to calculate
postcompliance financial ratios.2

       The ratio analysis relies on two financial measures:  ROA and ICR.3 ROA is a
comprehensive measure of company financial performance, whereas ICR is an indicator of a
company's ability to manage financial commitments.  Both measures are of great importance to
creditors and investors in deciding whether to provide investment capital.  The methods for
calculating both baseline and postcompliance ROAs and ICRs are described in more detail
below.
       6.1.1  Explanation of Ratios

       6.1.1.1 Return on Assets (ROA)

       ROA is a measure of the profitability of a company's capital assets, independent of
financial structure.  It is computed as the ratio of net income to assets:
                                     „_.. _ Net Income
                                     KUA	
                                           Total Assets
       If a company's ROA is lower than that of its competitors, the company might not be able
to provide the expected investment return to its creditors and investors.  Unless significant
improvement in performance is likely, investors and creditors generally will avoid providing
financing to such companies.  Alternatively, investors and creditors might seek higher returns (in
the form of higher interest rates or higher required returns on equity) to compensate for the
additional risk associated with the capital they provide. The higher cost of capital might in turn
         that where one facility has a statistical weight of 2, the model assumes that both
facilities are owned by the same firm, conservatively assigning impacts of two facilities to one
firm, except in the case of the firm/facilities, in which case, two firm/facilities are assumed.
   3The reason for choosing these two financial ratios over other available ratios is explained
more fully in Section 3.2.4.
                                           6-3

-------
decrease the likelihood that such companies will be able to invest in the treatment options
required for compliance with an effluent guideline.

       ROA is perhaps the single most comprehensive measure of a company's financial
performance.  ROA provides information about the quality of management, the competitive
position of a company within its industry, and the economic condition of the industry in which
the company competes.  In addition, ROA incorporates information about a company's operating
margin and asset management capability: the ratio of income to sales (operating margin),
multiplied by the ratio of sales to assets (asset turnover), equals ROA  If a company cannot
sustain a competitive ROA, on both a baseline  and postcompliance basis, it probably will have
difficulty financing the pollution control investment.  This is true regardless of whether financing
is to be obtained as debt or equity.
       6.1 J3 Interest Coverage Ratio (ICR)

       ICR is the ratio of EBIT to interest obligations:

                                       KR_ EBJT
                                           Interest

       ICR is equally as important to creditors and investors as ROA because it indicates the
extent to which the company can be expected to manage its financial burdens without risk of
financial failure. If a company's operating cash flow does not comfortably exceed its contractual
payment obligations (e.g., interest and lease obligations), the company is seen as vulnerable to
any significant decline hi sales or increase in costs.4 Should sales decline or costs rise, there are
two possible results:  (1) returns to the equity owners of the company either will be eliminated or
sharply reduced, and (2) the company will be prevented from meeting its contractual payment
obligations.  In the first  case, earnings might fall or become negative, with a consequent
reduction or elimination of dividends and/or reinvested earnings.  The market value of the
    4For this analysis, a company's operating cash flow is considered to be value of shipments
minus production costs, with the exception of interest, lease expense, and depreciation, where
distinguishable.
                                           6-4

-------
company's equity also is likely to fall, causing a capital loss to investors.  In the second case,
failure to make contractual credit payments will expose the company and its equity owners to the
risk of bankruptcy, forced liquidation of assets, and probable loss of the entire equity value  of the
company.
       6.1.2  Recalculating Ratios Incorporating Compliance Costs

        The data necessary to calculate baseline and postcompliance ROAs and ICRs are
available from the survey and engineering costs analyses. For the baseline analysis, ROA and
ICR are computed with the survey data after baseline facility closures are considered.  Baseline
closures can reduce net income at the firm level (if net income at the facility was positive).
Additionally liquidation of assets leads to some reduction in the firm's total assets because when
assets are liquidated, their total market value might not be realized. For the postcompliance
analysis, the relevant survey data (net income, EBIT, total assets, and interest expenses) are
adjusted to reflect annual compliance costs estimated at the facility level as well as any changes
in net income and assets caused by facility closures, if any.

       In the facility analysis, compliance costs are estimated in two categories: capital costs
(facility and equipment), and annual operating and maintenance costs.5 The sum of these
annualized costs over the nonclosing facilities owned by each company is used to adjust the
survey data as follows:
   5The operating and maintenance (O&M) cost category includes discharge costs (e.g., the cost
of sludge disposal) and monitoring costs.
                                            6-5

-------
(1)    Postcompliance Net Income or EBTT  =  Net Income or EBIT - S of Nonclosing Facilities'
       Annual Compliance Costs - [(£ of closing facilities' net income or EBIT) x tax factor6]
(2)    Postcompliance Total Assets = Total Assets + S Nonclosing Facility Capital Compliance
       Costs - E of Closing Facilities'Nonrecoverable Fixed Assets
(3)    Postcompliance Interest Expense = Interest Expense + E Annual Nonclosing Facility Interest
       Expense for Pollution Control Technologies
       6.1.3  Evaluating Baseline and Postcompliance Ratios

           .1 Baseline Analysis
       To evaluate the baseline viability of the companies analyzed, the baseline ROA and ICR
values are compared against the lowest quartile (25th percentile) values for the pharmaceutical
sector (SIC 283) in 1992 as reported by Robert Morris Associates (RMA, 1992) for ICR and
Dun & Bradstreet (D&B, 1993) for ROA.7 The benchmark values for ROA and ICR are 0.027
and 1.8, respectively.  Those companies for which the value of either the ROA or the ICR is less
than the first quartile value from RMA and D&B are judged to be vulnerable to financial failure,
independent of the application of a pharmaceutical  effluent  guideline.   Because both measures
are judged to be critically important to financial success and the ability to attract capital, failure
with regard to either measure alone is reason for finding the company to be financially
vulnerable.

       Where sufficient  data were available, three-year average  (1988-1990) ROAs and ICRs
were calculated and used as the baseline ratios. In  some cases, however, companies did not
provide sufficient net income, EBIT, assets, and interest payments data to calculate three-year
ROA and ICR averages.  In these cases, two-year ratio averages were used where possible.  For
         factor used for net income only.  This factor accounts for the fact that any loss or gain
of income will be net of taxes.  Note that baseline closures are accounted for during the baseline
analysis, so the net income, earnings, and asset adjustments for baseline closures are already
incorporated into the net income, EBIT, and assets at the beginning of the postcompliance
analysis. Thus, the closing facilities to be addressed in this equation are only those facilities that
close in the postcompliance analysis.
    'The affected firms make up only a portion of these larger pharmaceutical industry categories.
EPA determined that a substantial portion of the pharmaceutical industry does not discharge or does
not discharge pollutants of concern (see Section Two).
                                            6-6

-------
 several companies, only a single year of data was available. In three cases, the owner companies
 failed to provide sufficient data to calculate either ROA or ICR ratios. These firms were
 removed from the analysis.
       6.133, Postcompliance Analysis

       Standard Methodology

       The postcompliance analysis is undertaken primarily for those companies that are not
found to be vulnerable in the baseline analysis. For these healthier companies, if either of the
postcompliance ROA and ICR values fall below their respective benchmarks, then the company
is judged to be vulnerable to financial failure as a consequence of regulatory compliance; these
companies are said to sustain  a "significant impact" as a result of the regulation. This standard
analysis is identified as Baseline and Postcompliance Analysis 1, and the results of this analysis
are presented in Section 6.2.1.
       Alternative Methodologies

       The 25th percentile value for ROA and ICR is only one possible means of defining poor
financial performance and condition.  Use of these benchmarks implies that the weakest one-
fourth of companies in an industry are automatically in poor financial condition and at risk of
financial failure. By definition, such companies are in poorer condition than 75 percent of their
competitors. In spite of this, some (and possibly all) companies in the lowest quartile might still
be in good financial condition, particularly during periods of strong industry economic
performance. Alternatively, during a period of weak economic performance, more than 25
percent of the companies  in an industry might be in poor condition and at risk of failure.

       Additionally, some firms in vertically integrated conglomerates might not be showing
profits (i.e., although manufacturing and R&D are  undertaken at the owner company level, sales
are accounted for primarily at the parent company  level). The firm thus acts as "captive" to the

                                           6-7

-------
parent company.  Furthermore, because of the research-intensive nature of the pharmaceutical
industry, a startup firm might show many more years of loss before turning a profit.  This
characteristic is associated with the very long lead times from the creation of a new drug product
to its introduction to market.  Investors are aware of these long lead times and are likely to be
more tolerant of early losses because of the chances of high profit in the long term.  For these
reasons, the firms that, under the standard methodology, are considered likely to fail in the
baseline (and thus are not analyzed in postcompliance scenarios using the standard methodology)
are looked at more closely.

       This analysis of marginal  firm is undertaken as a sensitivity analysis because there is no
way of knowing whether these firms really can be credited with significant impacts from
compliance costs. This analysis provides an upper bound of potential impacts from compliance
costs.

       The worst-performing firms are divided between those with negative ROA and/or ICR
(which are the result of negative  net income or EBIT) and those with positive ROA and ICR.
For firms that have positive net income and/or EBIT, but whose ROA or ICR fall below
benchmarks, Postcompliance Analysis 2 looks  at the relative percentage change in ROA or ICR
as a result of compliance costs or facility closures. This analysis is undertaken to determine the
severity of impact (under a worst-case options scenario), assuming these firms do not, in fact,
close in the baseline. A percentage change in ROA or ICR of 5 percent or less is considered
minimal impact.  A change of more than 5 percent is considered a major impact.  The results of
this analysis are presented in Section 6.22.

       Changes in ROA or ICR  ratios that are already negative are difficult to present
meaningfully. However, the proportion of the postcompliance net income  or EBIT loss
attributable  to compliance costs provides a qualitative sense of impact. This analysis is presented
as Postcompliance Analysis 3, and results are summarized in Section 6.23. Those firms that have
a substantial net loss of income or earnings before even relatively large compliance costs are
incurred are most likely to fail whether or not compliance costs are incurred.  Firms with
minimal losses, on the other hand, might be able to survive, but only if compliance costs are not
substantial.  In this analysis, if worst-case compliance costs (i.e., the highest cost options are

                                           6-8

-------
chosen for all facilities) are 5 percent or less of the postcompliance net income or EBIT loss, we
determine that if the firm were to remain open, compliance costs would not be a major factor in
its continued viability.  A change of more than 5 percent is considered a major impact.

       All firms identified as potentially experiencing a major impact in Postcompliance
Analyses 2 and 3 are investigated further to determine the likelihood of baseline failure. Several
measures pointing to likely firm failure in the baseline are investigated. Unless two or more of
the following are true, the firm is considered highly likely to fail, even given the  reservations
noted above:

       •      Research and development expenditures are much higher than average

       •      The firm has facilities with startup dates of 1987 or later
       •      Rising net income  (more than 10 percent per year) is noted
       •      Rising working capital (more than  10 percent per year) is noted

Any facilities not identified as highly likely to fail in this analysis were then further assessed on a
case-by-case basis to determine if they constitute a potential upper bound on overall impacts
from the proposed effluent guidelines.
       Profitability Analysis Methodology

       One final analysis (Profitability Analysis) is undertaken to determine impacts on
profitability among firms estimated to have no significant impact from compliance costs in
Postcompliance Analysis 1 (significant impact here means likely to fail).  Compliance costs,
although not necessarily leading to the likelihood of firm failure, might have other major impacts
on a firm's financial outlook. Using the selected regulatory options, this analysis investigates the
percentage change in ROA among the healthy firms to assess impacts on profitability.  Again, a
5 percent change is used as a benchmark.  A change of 5 percent or less is considered a minimal
impact. A change  of more than 5 percent is considered a major impact (although potentially less
significant than firm failure).
                                            6-9

-------
       Also note that even if a company is considered likely to fail, this does not necessarily
mean that its nonclosing facilities also will close.  In the cases where a firm is considered likely to
fail, we assume that the company's viable facilities could be sold as part of the company
liquidation process and operated successfully under different ownership.  Alternatively, some
facilities might be sold (and continue to operate)  to raise the necessary capital to finance the
installation of pollution control equipment at the  remaining facilities. Thus firm closures are not
considered an indicator of additional facility-level impacts. The one  exception to this approach is
the analysis involving firm/facilities.  To be conservative, failing firm/facilities are assumed to  be
liquidated (similar to a facility closure).  In fact, firm/facilities might offer themselves for sale,
thus extending the life of the facility (although possibly not the  firm). Thus it is possible that
impacts on firm/facilities might be overstated.
6.2    RESULTS

       The results of the firm-level analysis are presented in three sections. Section 6.2.1
presents the basic firm-level analysis (Baseline and Postcompliance Analysis 1). This analysis
uses the standard methodology, outlined previously, in which baseline failures are estimated using
the lowest quartile ROA and ICR values for the industry as benchmarks. The postcompliance
portion of Analysis 1 is then developed using only the firms that are determined to have ROAs
and ICRs above benchmarks in the baseline (i.e., the financially healthy firms). Section 6.22
presents Postcompliance Analysis 2, which investigates potential impacts on firms with positive
net income or earnings that appear likely to fail in the baseline under Analysis 1.  Section 623
presents the results of Postcompliance Analysis 3. Firms with negative net  income or earnings
are analyzed in this third analysis to  determine how much more negative their income or
earnings might become if they incur the estimated compliance costs.  Finally, Section 6.2.4
presents the results of the profitability impacts analysis.  Firms that continue to appear financially
healthy following the installation and operation of pollution control equipment (i.e., those that
are not expected to fail as a result of the proposed regulation) are investigated to determine the
impact of compliance costs on their profitability as measured by declines in ROA. This analysis
is a measure of additional impact short of firm failure.
                                           6-10

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       6.2.1  Baseline and Postcompliance Analysis 1—Standard Methodology

       The baseline analysis for Analysis 1, which separates financially healthy firms from those
likely to fail regardless of whether the regulation is promulgated, is presented in Table 6-1.  As
the table shows, out of 187 firms in the survey universe, 54 (29 percent) are considered likely to
fail even before the impact of the effluent guideline requirements is considered8.  These firms
are projected to fail in the baseline and are not considered in the postcompliance portion of
Analysis 1.

       Tables 6-2 through 6-4 show the impacts associated with each proposed option, assuming
that only one option is in effect at any one time (i.e., if a firm owns an A/C direct and a B/D
direct facility, the impact of the BAT option for the A/C facility is tallied separately at the firm
level from the impact  of the BAT option for the B/D facility.  These tables reflect results of
analyses for firms owning A/C direct facilities (Table 6-2), B/D direct facilities (Table 6-3), and
indirect discharging facilities (Table 6-4).

       As the tables show, only one firm owning an A/C direct discharger is expected to fail and
only as a result of the most stringent option considered (see Table 6-2); no B/D direct
dischargers are expected to fail under any option (see Table 6-3). A maximum of only four firms
with A/C indirect facilities and six firms with B/D indirect facilities are expected to experience
significant impacts (i.e., to be likely to fail) under the most stringent regulatory options for these
industry subcategories (PSES-A/C#4 and PSES-B/D#3—see Table 6-4).  These 10 firms
represent 7.5 percent of all firms with A/C indirect facilities, 7.6 percent of all firms with B/D
indirect facilities, and  7.5 percent of all postcompliance firms.

       Table 6-5 examines the impacts generated by EPA's selected options. As can be seen in
the table, when all selected options are applied to the firms concurrently, two A/C indirect firms
   8Although this percentage seems high, it is an artifact of the benchmark.  On average 25
percent of pharmaceutical firms could be expected to fail if a 25th percentile benchmark is
chosen. The choice of this benchmark is thought to be realistic, however, given the high rates of
entry and exit seen in this industry (see Section Three). These failure rates do not imply that
over one-quarter of the industry will fail in any one year; rather over a reasonable period, these
weaker firms are considered likely to fail, even if the regulation is not imposed.
                                           6-11

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                                        TABLE 6-1

                                  BASELINE ANALYSIS

Firms with A/C Direct Facilities
Firms with B/D Direct Facilities
Finns with A/C Indirect Facilities
Firms with B/D Indirect Facilities
Firms with A/C Nondischarging Facilities
Firms with B/D Nondischarging Facilities
Total
Number
of Firms
19
11
70
107
4
3
Financially
Healthy Firms
#of
Firms
15
7
53
72
2
3
%of
Group
78.9%
63.6%
75.7%
67.3%
50.0%
100.0%
Firms Likely
to Fail
#of
Firms
4
4
17
35
2
0
%of
Group
21.1%
36.4%
24.3%
32.7%
50.0%
0.0%
% of All
Firms*
2.1%
2.1%
9.1%
18.7%
1.1%
0.0%

All Firms**
187
133! 71.1%
54
28.9% | 28.9%
* Out of all firms in the analysis (187 firms).
** Number of firms for All Firms might be less than the total firms by subcategory because some
firms have more than one type of facility.  Total number of All Firms includes firms that have
nondischarging facilities

Note: Analysis excludes three firms because of lack of financial data.

Source: ERG estimates.
                                           6-12

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                              TABLE 6-2

                   POSTCOMPLIANCE ANALYSIS 1
A/C DIRECT DISCHARGE REGULATORY OPTIONS (15 AFFECTED FIRMS)*
Regulatory
Option
Total
Number
of Firms*
No Significant
Impact
#of
Firms*
%of
Group
Significant
Impact
#of
Firms*
%of
Group
% of All
Firms**
BPT Options
BPT-A/C#1
BPT-A/C#2
BPT-A/C#3
BPT-A/C#4
BPT-A/C#5
15
15
15
15
15
15
15
15
15
15
100.0%
100.0%
100.0%
100.0%
100.0%
0
0
0
0
0
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
BCT Options
BCT-A/C#1
BCT-A/C#2
BCT-A/C#3
15
15
15
15
15
15
100.0%
100.0%
100.0%
0
0
0
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
BAT Options
BAT-A/C#1
BAT-A/C#2
BAT-A/C#3
BAT-A/C#4
15
15
15
15
15
15
15
14
100.0%
100.0%
100.0%
93.3%
0
0
0
1
0.0%
0.0%
0.0%
6.7%
0.0%
0.0%
0.0%
0.7%
* Number of firms remaining after baseline analysis that have A/C direct discharge facilities.
** Out of all firms in the postcompliance analysis (133 firms). Note that the numbers of
facilities in Tables 6-2 through 6-4 total more than 133, because several firms have more
than one type of facility.

Source: ERG estimates.
                                  6-13

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                              TABLE 6-3

                    POSTCOMPLIANCE ANALYSIS 1
B/D DIRECT DISCHARGE REGULATORY OPTIONS (7 AFFECTED FIRMS)*
Regulatory
Option
Total
Number
of Firms*
No Significant
Impact
#of
Firms*
%of
Group
Significant
Impact
#of
Firms*
%of
Group
% of All
Firms**
BPT Options
BPT-B/D#1
BPT-B/D32
BPT-B/D#3
7
7
7
7
7
7
100.0%
100.0%
100.0%
0
0
0
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
BCT Options
BCT-B/D#1
BCT-B/D#2
7
7
7
7
100.0%
100.0%
0
0
0.0%
0.0%
0.0%
0.0%
BAT Options
BAT-B/D#1
BAT-B/D#2
BAT-B/D#3
BAT-B/D#4
7
7
7
7
7
7
7
| 	 7
100.0%
100.0%
100.0%
100.0%
0
0
0
0
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
* Number of firms remaining after baseline analysis that have B/D direct discharge facilities
** Out of all firms in the postcompliance analysis (133 firms). Note that the numbers of
facilities in Tables 6-2 through 6-4 total more than 133, because several firms have more
than one type of facility.

Source: ERG estimates.
                                 6-14

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                              TABLE 6-4

                   POSTCOMPLIANCE ANALYSIS 1
         PSES INDIRECT DISCHARGE REGULATORY OPTIONS
Regulatory
Option
Total
Number
of Firms*
No Significant
Impact
#of
Firms*
%of
Group
Significant
Impact
#of
Firms*
%of
Group
% of All
Firms**
PSES-A/C Options
PSES-B/D#1
PSES-B/D#2
PSES-B/D#3
PSES-B/D#4
53
53
53
53
51
51
50
49
96.2%
96.2%
94.3%
92.5%
2
2
3
4
3.8%
3.8%
5.7%
7.5%
L 1.5%
1.5%
2.2%
3.0%
PSES-B/D Options
PSES-B/D#1
PSES-B/D#2
PSES-B/D#3
79
79
79
78
78
73
98.7%
98.7%
92.4%
1
1
6
1.3%
1.3%
7.6%
0.7%
0.7%
4.5%
* Number of firms remaining after baseline analysis that have indirect discharge facilities.
** Out of all firms in the postcompliance analysis (133 firms). Note that the numbers of
facilities in Tables 6-2 through 6-4 total more than 133, because several firms have more
than one type of facility.

Source: ERG estimates.
                                6-15

-------
                                      TABLE 6-5

                           POSTCOMPLIANCE ANALYSIS 1 *
                         SELECTED REGULATORY OPTIONS

Firms with A/C Direct Facilities
Firms with B/D Direct Facilities
Finns with A/C Indirect Facilities
Finns with B/D Indirect Facilities
Total
Number
of Firms
15
7
53
72
No Significant
Impact
#of
Firms
15
7
51
71
%of
Group
100.0%
100.0%
96.2%
98.6%
Significant
Impact
#of
Firms
0
0
2
1
%of
Group
0.0%
0.0%
3.8%
1.4%
% of All
Firms**
0.0%
0.0%
1.5%
0.7%

AllFirms-)-
133
130
97.7%
3
2.3%
2.3%
* This scenario analyzes impacts from regulating A/C Direct facilities under options BAT-A/C#2
and BPT-A/C#2, B/D Direct faculties under options BAT-B/D#1 and BPT-B/D#2, A/C Indirect
facilities under option PSES-AOl, and B/D Indirect facilities under option PSES-B/D#1.
** Out of all firms in the postcompliance analysis (133 firms).
+ Number of firms for All Finns might be less than the total firms by subcategory because some
firms have more than one type of facility.  Total number of All Firms includes firms that have
nondischarging facilities

Note: Analysis excludes three firms because of lack of financial data.

Source: ERG estimates.
                                         6-16

-------
and one B/D indirect firm are expected to be likely to fail as a result of the proposed effluent
guidelines.  Additionally, the one B/D indirect firm is a firm/facility, which is therefore assumed
to be liquidated (i.e., closed). Note, however, that this is an upper-bound estimate of significant
impacts, since zero-cost passthrough is assumed. A market-based model might show fewer or
even no firm failures.  The same results are obtained under the alternative regulatory scenario
(the in-plant steam stripping/distillation scenario; see Appendix C).
       6.2.2 Postcompliance Analysis 2

       Tables 6-6 and 6-7 present the results of the analysis of firms that are estimated to fail in
the baseline analysis but that have positive EBIT or net income.  This analysis investigates
whether compliance cost impacts on these marginal firms would be onerous, if they did not fail
for other reasons. As Table 6-6 shows, changes in ICR (shown in absolute value) in these
marginal firms are insignificant in many cases. Nearly a third of the firms (9 firms) in this group
show no change in ICR. More than two-thirds are estimated to incur changes in ICR of
5 percent or less (20 firms). A total of nine firms, or about 31 percent of marginal firms with
positive EBIT, would be expected to incur substantial impacts (i.e., greater than 5 percent
change) if they do not fail for other reasons  (see Section 6.2.4 for a more in-depth analysis of
how likely these firms are to fail in the baseline).

       Table 6-7 presents a similar analysis for ROA among marginal firms with positive  net
income. Nine firms in this category incur changes in ROA (again in absolute values) of 5
percent or less (45 percent).  Eleven firms (55 percent of the marginal firms with positive ROA),
however, would be expected to incur substantial impacts (i.e., decline in ROA greater than 5
percent) if these firms do not fail for other reasons (see Section 6.2.4 for a more in-depth
analysis of how likely these firms are to fail in the baseline).
                                           6-17

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       6.2.3  Postcompliance Analysis 3

       Tables 6-8 and 6-9 present the results of an analysis of declines in EBIT and net income
for firms where EBIT or net income is already negative in the baseline. The analysis measures
absolute changes in EBIT and net income. As Table 6-8 shows, 19 firms (76 percent) with
negative EBIT would incur changes in EBIT of 5 percent or less (i.e., EBIT becomes more
negative, but only by 5 percent or less of the firm's existing loss).  Only six firms (24 percent of
firms with negative EBIT) are thus estimated to incur substantial impacts if they do not fail for
other reasons (see Section 6.2.4 for a more in-depth analysis of how likely these firms are to fail
in the baseline).

       Table 6-9 presents the change in net income among firms with negative net income in the
baseline. Twenty-nine firms  (85 percent) are associated with a change in net income of 5 percent
or less.  Only five firms (or 15 percent) would be expected to incur substantial impacts if they do
not fail for other reasons (see Section 6.2.4 for a more in-depth analysis of how likely these firms
are to fail in  the baseline).
       6.2.4 Further Investigation into Likelihood of Firms Failing in the Baseline

       As Sections 6.2.2 and 6.23 indicate, 9 firms with positive EBIT projected to fail in the
baseline analysis are expected to incur a change in ICR of greater than 5 percent; 11 firms with
positive net income will incur a change in ROA of greater than 5 percent; 6 firms with negative
EBIT will incur changes in EBIT of more than 5 percent, and 5 firms with negative net income
will incur changes in net income of more than 5 percent.

       Many of these firms overlap in these counts, thus only 16 firms identified as likely to fail
in the baseline are considered likely to incur major impacts if they do not actually fail.  These 16
firms are analyzed in more detail in Table 6-10. In this table various measures of potential
financial viability are assessed. Where two or more items are noted as "yes," it is assumed that
baseline failure might not occur and that some unusual factors, such as facility startup costs or
unusually high R&D expenditures, are causing a superficial appearance of poor financial health.
                                          6-20

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                                        6-23

-------
As the table shows, three firms (Numbers 5,12, and 14) showed substantial increases in net
income and working capital over the 3-year period of data collection (one firm had insufficient
data to confirm or deny the baseline failure assessment). Net income at two of the three firms,
although showing improvements, remained quite negative in all 3 years and no other mitigating
factors (such as a new facility or high R&D expenditures that might explain the negative income)
were present.  Thus there is no evidence that their financial health is other than what was
determined in the baseline analysis. The third firm, however, showed outstanding growth in net
income, going from negative to strongly positive in 1990. The firm's 1990  financial picture,
therefore, was considered more likely to represent its future trend than the average of the three
years of financial data. If this assumption is used, the firm would pass the baseline analysis with
an ROA of 22 percent and no debt payments (i.e., ICR = infinity).  When compliance costs are
considered, its ROA drops only to 21 percent and its ICR is excellent.  Thus even if this firm
were not to fail in the baseline, if its financial health continues strong in future years, this firm
should have no difficulty affording to comply with the regulation.

       In summary, the results of this last analysis indicate that the baseline analysis was
reasonably accurate in identifying firms in poor health.  Thus the results of Postcompliance
Analysis  1 can be reasonably assumed to represent an upper bound on firm-level impacts from
the selected regulatory options.
       6.2.5  Profitability Analysis

       Table 6-11 presents the results of an analysis to determine the effects of the selected
regulatory options on profitability, measured as ROA, among firms that are considered healthy in
the baseline and in Postcompliance Analysis 1. As the table shows, 82 firms (nearly 85 percent
of all healthy, noncertifying firms) are associated with declines in ROA of 5 percent or less.
Fifteen firms are anticipated to have more substantial impacts; only one firm is expected to
experience impacts of greater than 50 percent. Only one direct discharging firm (an A/C direct)
will have a change in ROA of greater  than 5 percent. Firms with indirect discharging facilities
bear more impacts.   Six A/C indirect dischargers are expected to experience changes in ROA
exceeding 5 percent. Eight firms with B/D indirect  discharges are expected to experience a

                                           6-24

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-------
change in ROA of more than 5 percent. When certifying firms are included in the analysis, the
15 firms estimated to incur major impacts on ROA are only 11 percent of all firms in the
postcompliance analysis. Furthermore, if some passthrough of compliance costs are possible,
these impacts could be much lower.

       Although these firms have large declines in ROA, it is useful to note that the average
baseline ROA among these firms is 27 percent, which is well above industry average.  Thus even
with large declines, postcompliance ROA is probably substantial.

       These results are broken down by firm size in Section Nine in the discussion of the
regulatory flexibility analysis.
63    REFERENCES
Dun & Bradstreet Information Services. 1993. Industry Norms and Key Business Ratios:
Desk-Top Edition. New York: Dun & Bradstreet.
Robert Morris Associates. 1992. Annual Statement Studies. Philadelphia, PA: Robert Morris
Associates.
                                         6-26

-------
                                  SECTION SEVEN
             EMPLOYMENT AND COMMUNITY-LEVEL IMPACTS
       This section of the EIA investigates employment and community-level impacts resulting
from compliance with the proposed effluent limitations guidelines for the pharmaceutical
industry.  Compliance with the proposed effluent guidelines imposes a cost at both the facility
and the firm level.  The expenditures to meet the regulatory standards might result in facility
closures and firm failures and thereby a loss in employment. This primary loss in employment
can lead to reduced production in the industries that supply inputs to the pharmaceutical
industry, thus leading to secondary employment losses.  These secondary losses are calculated by
using product input-output tables that take into account geographic and industrial patterns and
the associated employment changes. When total primary and secondary  losses are compared to
employment  levels in the communities in which the firms and facilities are located, community-
level impacts can be determined.  These losses are, however, offset to some extent by the need to
hire workers to manufacture, install, and maintain the pollution control equipment.  This
increase in economic activity results in employment gains in the related industries and is factored
into this analysis.

       The analysis in this section is divided into three parts. Section 7.1 examines primary and
secondary employment losses, presenting the methodology and results of the employment losses
and community-level impacts resulting from baseline and postcompliance facility closures and
firm failures. Section 7.2 analyzes labor requirements and potential employment benefits from
the manufacture, installation, and  maintenance of the necessary pollution control equipment.
Finally, Section 7.3 presents the net employment impacts of the proposed regulation.
                                         7-1

-------
7.1    PRIMARY AND SECONDARY EMPLOYMENT LOSSES

       7.1.1 Introduction

       Primary employment losses occur only within the targeted pharmaceutical manufacturing
industry. Secondary impacts include employment losses in other industries providing inputs to
the pharmaceutical manufacturing process and other supporting industries such as community-
based services that lose income when layoffs occur; these losses would result from any significant
decline in demand for inputs as well as from regional reductions in personal income.

       Primary and secondary employment losses are summed to obtain the total impact on
community employment levels resulting from implementation of the effluent guidelines.
Although secondary employment losses do not necessarily occur at the community level (since
national multipliers cannot differentiate between input sources within and outside the
community), they are included in this analysis to present a conservative estimate of all potential
employment losses.
       7.1.2 Methodology

       7.13.1  Primary Employment Losses

       Primary employment losses consist of employee layoffs associated with the facility
closures estimated in the facility-level analysis and firm failures in the firm-level analyses. These
job losses are estimated from survey data on annual employment hours.

       Three types of employment losses (measured in hours) are estimated and summed to
estimate total employment losses.  Losses are calculated for facilities, for facilities that are also
firms (known here as firm/facilities—see Section Five), and firms where the firm and the facility
are not the same entity (multifacility  firms). Facility closures are considered a liquidation (not a
                                          7-2

-------
sale), thus all employees of the facility are assumed to lose their jobs.  Total direct job losses are
equal to the total employment at the closed facility.1

       Firm/facilities (where the firm and the facility are the same entity) are not analyzed in the
facility closure analysis, but in the firm failure analysis.  Thus, these firm/facilities are not
assumed to be liquidated based on the facility-level analysis.  Instead they are analyzed to
determine whether they can absorb the costs of compliance and still be considered financially
healthy, i.e., not likely to fail (based on an analysis of standard financial ratios). If firm/facilities
are shown to be likely to fail under a regulatory option, the total employment of the firm/facility
is counted as an employment loss and added to those losses accounted for under the facility
closure analysis.  Note that this assumption is conservative.  If the present value of net income at
the firm/facility is not too low after accounting  for compliance costs, the facility might be
purchased by another firm.

       Multifacility firms also are analyzed to determine whether they are likely to fail under the
various regulatory options.  Employment losses at the firm level are more difficult to quantify,
since the Section 308 Survey did not obtain information on firm-level employment.  Therefore 10
percent of the total employment at all the facilities owned by the firm was used as a proxy for
employment strictly related to the administrative  functioning of the firm:

       Total employment of all facilities * 0.1 =  Total nonfacility employment at the firm level.

       If a firm is shown to be likely to fail, we assume that this nonfacility  employment is lost,
representing administrative and executive staffing at the firm level only. Note that facilities that
          closures are estimated based on an analysis of the salvage value of the facility vs. the
present value of net income at the facility. If the salvage value of the facility exceeds the present
value of net income of the facility (estimated based on data from the Section 308 Survey), the
firm is projected to liquidate the facility.  Thus closures are considered the loss of a facility in
contrast to a sale, which is considered the transfer of a facility to new ownership. All facilities
that are projected to remain in operation  in the baseline case (i.e., without the regulation) are
assigned annual costs of compliance with the effluent guideline option under consideration.
These costs in turn reduce facility net income.  If the salvage value is greater than the new
present value of net income, these facilities are considered to close and the closures are assigned
to the regulatory option under consideration (see Section Five).
                                            7-3

-------
do not close as a result of the proposed guidelines are assumed to be sold intact with no loss of
employment when their owner company fails. Thus no additional employment losses are
associated with firm failure beyond the 10 percent factor discussed above. This estimate of firm-
level employment losses also is added to the number of employee losses projected under the
other two analyses.

       Total employee hours lost because of a facility closure or firm failure (i.e., the sum of
pharmaceutical production and nonproduction hours) are converted to fulltime equivalents
(FTEs), assuming that 2,080 hours (52 weeks/year x 40 hours/week) equals one FTE. The
analysis is divided into two stages. The first stage analyzes the employment losses associated with
baseline closures and failures (i.e., those closures and failures that are expected to occur even
without the proposed effluent guidelines).  The second stage  calculates the closures associated
with compliance with the selected options.  These postcompliance employment losses in
employment are then converted into FTEs.
       7.12.2  Secondary Employment Losses

       Secondary losses in employment occur in other industries providing inputs to the
pharmaceutical manufacturing industry and are caused by reduced demand for these inputs.
Secondary impacts are assessed through multiplier analysis, which measures the extent of impacts
in other industries as a function of impacts in the primary industry. Multiplier analysis provides
a straightforward framework as long as the direct effects are small and certain limiting
assumptions about technology are valid (e.g., constant returns to scale, fixed input ratios).

       The multiplier used in this analysis is based on input/output tables developed by the
Department of Commerce, Bureau of Economic Analysis (BEA, 1992). The BEA multipliers are
estimated using the Regional Industrial Multiplier System (RIMS II)  developed by the Regional
Economic Analysis Division of the BEA. The multipliers reflect the total national change in the
                                           7-4

-------
number of jobs given a change in the number of jobs for a particular industry.2  In this analysis,
the industry directly affected is the Drugs Industry (SIC 283).3  The multiplier reported by BEA
for this industry is 5.95.4 The total number of job losses, both primary and secondary, is
computed as the primary losses in pharmaceutical industry jobs (measured in FTEs) multiplied
by 5.95:

            Total job losses = 5.95 * Primary losses in the Pharmaceutical Industry

These secondary losses are calculated both for the baseline analysis and for each option,
postcompliance.
       7.12.3 Measuring Impacts at the Community Level

       The significance of employment losses on the community is measured by their impact on
the community's overall level of employment. Data necessary to determine the community
impact include the community's total labor force and employment rate.  The community
employment information used in this analysis is from the end-of-year 1990, as estimated by the
Bureau of Labor Statistics. For purposes of this analysis, the community is defined as the
Metropolitan Statistical Area (MSA) in which the facility is located and is assumed to represent
the labor market area within which residents could reasonably commute to work.5 If the facility
is located in a Primary Metropolitan Statistical Area (PMSA) within the MSA, then the PMSA
   2 Employment multipliers for a given industry show the number of full- and part-time jobs
that the industry provides, both directly and indirectly, given a $1 million change in final demand.
   'Multipliers based on direct employment changes are available at an aggregated industry level
only.
   The use of this national multiplier might overstate the number of jobs affected within the
community because some of the inputs might be from sources outside the community or even
outside the country.  No multipliers that differentiate among the locations of input sources are
known to exist.
   5MSAs are defined by the U.S. Office of Management and Budget.
                                          7-5

-------
total labor force is used.  If a facility is not located within an MSA, then the community's total
labor force is defined as the total labor force of a county (or township, for eastern states).

       This analysis too,  is divided into a baseline and postcompliance analysis.  For simplicity,
baseline losses are analyzed  only if there is a postcompliance closure or failure in the same
community.  In that case  baseline losses are subtracted from current employment numbers to
reduce the base employment and possibly the base employment rate in the community of
concern.  An increase in the community employment rate equal to or greater than one percent is
considered significant.  This  impact would correspond to a considerable change in the community
employment rate.
      -7.1.3 Results

       7.13.1  Employment Impacts

       Baseline Losses: Primary and Secondary Employment Losses

       As discussed above, employment losses are counted when a facility closes (100 percent of
facility employment), when a firm/facility fails (100 percent of facility employment) and when a
firm fails (10 percent of facility employment for all facilities owned).

       Table 7-1 presents the results of primary employment losses in the baseline. As the table
shows, before any compliance costs are incurred,  14,381 jobs are estimated to be lost, out of a
total employment of 147,804 workers6 (9.7 percent of total employment in the affected portion
of the industry). These losses are associated with 38 facility closures, 21 firm/facility failures, and
33 firm failures. The baseline analysis predicts that secondary job losses will total 85,567, using
the multiplier of 5.95 (as discussed in Section 7.12). These baseline losses constitute an
   6In the affected portion of the pharmaceutical industry. Employment at other pharmaceutical
firms not covered by the proposed effluent guidelines is not counted here.
                                           7-6

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                                        7-7

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insignificant portion (0.07 percent) of national employment (which totaled 117.9 million in 1990),
thus these losses have a negligible impact on national-level employment rates.

       Table 7-2 presents baseline employment losses categorized by facility employment size
(thus it excludes firm-level losses and includes only facility and firm/facility losses).  The largest
percentage of baseline job losses as a proportion of total employment within an employment size
group is in the two smallest employment categories (1 to 18 and 19 to 167 employees). A total
of 72 out of 237 jobs, or 30 percent, are expected to be lost in the baseline among the smallest
employment size group (1-18 employees), and 3,402 out of 8,523 jobs, or 40 percent, among the
next smallest employment size group (19-167 employees).
       Postcompliance Losses: Primary and Secondary Employment Losses

       Tables 7-3 and 7-4 cover employment losses among the A/C and B/D direct dischargers,
respectively.  Among the A/C direct dischargers, only BAT-B/D#4 results in any impacts. One
facility is expected to close and one firm/facility is expected to fail, leading to total employment
losses of 62 FTEs. No facility closures or firm failures are expected to occur as a result of any of
the regulatory options  for B/D direct dischargers, thus no employment losses are predicted for
this group.

       Table 7-5 presents employment losses associated with PSES options for indirect
dischargers. Losses range from those for PSES-A/C#1, which is expected to result in two firm
failures and an estimated loss of 78 FTEs (based on the 10 percent employment loss factor used
for firm failures) to those for the most stringent option, PSES-A/C#4. This latter option results
in four firm/facility or  firm failures. These establishments are associated with job losses totaling
224 FTEs.

       Employment losses for B/D indirect dischargers range from 13 FTEs under PSES-B/D#1,
which is expected to result in one firm/facility failure, to 392 FTEs associated with PSES/B/D#3.
This most stringent option results in a total of six firm or firm/facility failures.
                                           7-8

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       Table 7-6 summarizes the facility- and firm-level primary employment losses for the
selected regulatory option (BAT-A/C#2, BAT-B/D#1, PSES-A/C#1 and PSES-B/D#1).  As the
table shows, all the employment losses occur in the indirect discharge category.  Two firms
(owning A/C indirect discharging facilities)  are predicted to fail as a result of complying with
PSES-A/C#1, leading to an estimated loss of 78 FTEs.  One B/D indirect firm/facility also is
predicted fail as a result of PSES-B/D#1, leading to a loss of 13 FTEs. Total estimated primary
employment losses thus total 91 out of 133,423 jobs in the affected industry (accounting for
baseline employment losses), or 0.07 percent of total employment for the affected portion of the
industry. Secondary losses are estimated at 541 FTEs, using the multiplier of 5.95.  These losses
are negligible when compared to total U.S. employment and will have no impact on national-
level employment rates.  The same results are obtained when the alternative regulatory scenario
(in-plant steam stripping/distillation) is considered (see Appendix C).

       Note that two out of three firms and firm/facilities projected to fail under the selected
regulatory scenario employ fewer than 750 employees. The affected firms range in size from 13
to 755 total employees (measured as FTEs).
       7.132  Community-Level Impacts

       The three firms estimated likely to fail as a result of the selected regulatory options are
located in two areas, a small county with an employed population of about 45,000 and an
unemployed population of about 4,400 and the CMSA of New York and Northern New Jersey
with nearly 8 million employed persons. In the first case, the employment rate drops by 0.01
percent due to a loss of 69 FTEs. In the other case, employment rate changes are negligible
(FTEs lost total 22). Thus no community-level impacts are expected.
                                          7-13

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7.2    LABOR REQUIREMENTS AND POTENTIAL EMPLOYMENT BENEFITS

       7.2.1  Introduction

       Firms will need to install and operate pollution control systems to comply with an
effluent limitations guideline for the pharmaceutical industry. The manufacture, installation, and
operation of these systems will require use of labor resources. To the extent that these labor
needs translate into employment increases in affected firms, an effluent guideline for the
pharmaceutical industry has the potential to generate employment benefits. If realized, these
employment benefits might at a minimum partially offset the employment losses that are
expected to occur in facilities affected by the rule. The employment effects that would occur in
the manufacture, installation, and operation  of treatment systems are termed the "direct"
employment benefits of the rule.  Because these employment effects are directly attributable to
the pharmaceutical industry rule, they are conceptually parallel to the primary employment losses
estimated as a result of the rule. This section looks at the employment gains (benefits)
associated with the selected regulatory options  only.

       In addition to direct employment benefits, the proposed guidelines might generate other
employment benefits through two mechanisms.  First, employment effects might occur in the
industries that are linked to the industries that manufacture and install compliance equipment;
these effects are termed "indirect" employment benefits. For example, a firm that manufactures
the pumps, piping, and other hardware that make up a treatment system will purchase
intermediate goods and services from other firms and sectors of the economy. Thus, increased
economic activity in the firm that manufactures the treatment system components has the
potential to increase activity and employment in these linked firms and sectors. Second, the
increased payments to labor in the directly and indirectly affected industries will lead to
increased purchases from consumer-oriented service  and retail businesses, which in turn lead to
additional labor demand and employment benefits in those businesses. These effects are termed
"induced" employment benefits.

       In view of these possible employment benefits, EPA estimated the labor requirements
associated with compliance with the proposed regulatory options as outlined in Section Four.
                                          7-15

-------
The following discussion summarizes the findings from this effort. Labor requirements—and
thus the possible employment benefits—were estimated in two steps. First, the direct
employment effects associated with the manufacture, installation, and operation of the
pharmaceutical industry compliance equipment were estimated.  These effects are discussed in
Section 122. Second, EPA considered the additional employment effects that might occur
through the indirect and induced effect mechanisms outlined above; these effects are discussed in
Section 7.23.
       7.2.2 Estimating Direct Labor Requirements

       As discussed above, an effluent guideline for the pharmaceutical industry will create
demand for labor services for manufacturing, installing, and operating compliance equipment.
EPA analyzed each of these components of direct labor requirements separately.  The sum of the
estimated requirements for the three labor categories represents the estimated total direct labor
requirement, and thus the potential direct employment benefit, from compliance with the
effluent guideline.
       722.1 Direct Labor Requirements for Manufacturing Compliance Equipment

       The direct labor requirements for manufacturing compliance equipment are estimated
based on the cost of the equipment and labor's expected contribution to the equipment's value in
its manufacture. Labor's contribution was estimated in dollars and was converted to an FTE
equivalent based on a yearly labor cost. Each component of the calculation is discussed below.
       Cost of Compliance Equipment

       The cost of compliance equipment was presented in Section Four for each of the
regulatory options. Compliance equipment requirements and their associated costs for each
facility included in the Section 308 Survey were used where applicable. For the labor
                                          7-16

-------
 requirements analysis, compliance costs and their associated labor requirements were considered
 only for those facilities that were not assessed either as a baseline closure or as a postcompUance
 closure. That is, the analysis considers the labor requirement effects associated only with those
 facilities that were assessed as likely to comply with the rule and continue pharmaceutical
 production activities. These costs were weighted, where appropriate, according to the number of
 facilities each sampled facility represents in the underlying pharmaceutical industry population
 and summed to give an aggregate compliance equipment cost for the industry. The total
 estimated one-time capital equipment cost in 1990 dollars for complying with the selected
 regulatory options for A/C and B/D direct dischargers and A/C and B/D indirect dischargers is
 $153.0 million (see Table 4-7).7
       Labor's Expected Contribution to the Equipment's Value

       Input-output tables assembled by BEA provide information on the composition of inputs
used to produce the outputs of industries in the U.S. economy (BEA, 1991a, b [1982 data])8.
The inputs tallied in the input-output tables include the purchase of intermediate goods,
materials, and services from other industries as well as the use of labor by the subject industry.
In particular, the direct requirements matrix identifies the value of each input, including labor,
that is required to produce a one-dollar value of output for a subject industry.  From discussions
with the EPA technical contractor on this effluent guideline project, the "Heating, Plumbing, and
Fabricated Structural Metal Products Industry" (BEA Industry Classification 40) was identified as
the industry with output that most nearly matches the types of equipment needed for compliance
with the pharmaceutical industry effluent guideline.  From the direct requirements matrix, the
    7The $153.0 million is the one-time outlay for purchasing the capital equipment estimated to
be needed for compliance with the regulation and is not the annual cost of the capital
equipment.  In the economic impact analysis, the capital outlay is annualized over a 16-year
period (including a one-year lag between equipment purchase and operation attributable to
installation) and the resulting value, which is part of the total annual cost of compliance, is much
less than the $153.0 million value.
    8The 1982  tables are the most current information on the interindustry input-output structure
of the U.S. economy.
                                           7-17

-------
labor input, titled, Compensation of Employees, accounts for $0.31016 of each dollar of output
value from the Heating, Plumbing, and Fabricated Structural Metal Products Industry.
Multiplying labor's share of output value (031016) times the value of equipment purchases for
complying with the rule yields labor's contribution to manufacturing the compliance equipment,
measured in terms of gross compensation.

       The estimated total costs of acquiring compliance equipment is $153.0 million. However,
this includes costs for facilities that will close in the baseline, regardless of regulatory cost. After
baseline and postcompliance facility closures and firm/facility failures are accounted for and their
compliance costs excluded, the total capital cost of purchasing the equipment is $133.4 million.
Only 90 percent of these costs are for the equipment itself. The remaining 10 percent is for
installation (see Section 7.2.2.2 for more details).  Thus total expenditures on equipment are
$120.0 million. Labor's contribution is estimated to be $37.2 million ($031016 percent x $120.0
million).

       The manufacture of compliance  equipment is considered a one-time event that occurs at
the beginning of industry's compliance activities.  Accordingly, the labor requirements for
manufacturing compliance equipment should be viewed as a one-time requirement. Elsewhere in
this economic impact analysis, the labor effects associated with facility impacts  are presented on
an annual basis, with the expectation that these job effects would persist  over the period of
analysis. Accordingly, for consistent assessment of the possible labor requirement effects from
manufacturing compliance equipment, it was necessary to annualize  the one-time labor effect.
Consistent with the annualization procedures elsewhere in the economic impact analysis, the one-
time labor compensation value of $37.2 million was annualized over a 16-year period at a social
discount rate of 7 percent as recommended by OMB (OMB, 1992).  The social discount rate is
used rather than the industry discount rate because the social impacts are being assessed here,
and not impact on industry.  The resulting annual value of gross labor compensation in
manufacturing compliance equipment is $3.9 million.
                                          7-18

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       Conversion to Fulltime Employment Equivalent Basis

       To convert the gross payment to labor to FTEs, the payment to labor was divided by an
estimated yearly labor cost. The yearly labor cost is based on the same labor cost, $27.74 per
hour, used in the engineering cost analysis to estimate  the cost of operating compliance
equipment.  The $27.74 per hour is a comprehensive labor cost including an allowance for fringe
benefits (e.g., holidays, vacation, and various insurance) and payroll taxes, and was calculated in
1990 dollars. Assuming a 2,080 hour work-year, the gross annual labor cost per full-time
employment position is $57,699.  On a one-time, one-year basis (i.e., not annualized), the $37.2
million labor outlay for manufacturing compliance equipment is estimated to require 645 FTEs.
On an annualized basis, the $3.9 million of gross labor cost for manufacturing compliance
equipment is estimated to require 68 FTEs.
       7.22.2 Direct Labor Requirements for Installing Compliance Equipment

       EPA estimated the direct labor requirements for installing compliance equipment in a
parallel manner to that used for analyzing the labor requirements for manufacturing compliance
equipment. Each component of the calculation is discussed below.
       Cost of Installing Compliance Equipment

       The cost of installing compliance equipment was estimated in conjunction with estimating
the purchase cost of compliance equipment. Specifically, on the basis of the kind, scale, and cost
of compliance  equipment assessed for a facility, the technical contractors estimated an
installation cost for the equipment. The installation costs are calculated based on the assumption
that installation is typically equal to 10 percent of the total capital cost. This assumption is taken
from Peters and Timmerhaus (1980), which states that installation costs are typically 6 to 14
percent of fixed capital costs for new plant construction or construction of additions to existing
                                          7-19

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facilities.9 The estimated installation costs averaged about 10 percent of the purchase cost of
the compliance equipment ($133.4 million) for a total of $13.3 million.
       Labor's Expected Contribution to the Equipment's Value

       The BEA industry group that EPA used as the basis for estimating labor's share of cost
in installing compliance equipment is the "Repair and Maintenance Construction Industry" (BEA
Industry Classification 12). In this industry group, gross payments to labor account for $0.42233
of each dollar of output value, as recorded in the direct requirements matrix for the national
input-output tables. Multiplying labor's share of value (0.42233) by the estimated total
installation cost ($133 million) yields a gross labor cost for compliance equipment installation of
$5.6 million.  Like the purchase cost of compliance equipment, the installation cost is a one-time
outlay and, accordingly, an annualized value was calculated using the 16-year amortization period
and the 7 percent social discount rate. The resulting annual value for the labor cost of installing
compliance equipment is $0.6 million.
       Conversion to Fulltime Employment Equivalent Basis

       Conversion to an FTE equivalent basis is based on the same yearly labor cost, $57,699, as
used in estimating the labor requirements for the manufacturing of compliance equipment. On a
one-time, one-year basis, 98 FTEs are estimated to be required  for installing the equipment
needed to comply with the selected regulatory options based on the $13.3 million gross labor
cost. Annualized over 16 years, the corresponding labor requirement for installing compliance
equipment is 10 FTEs.
   'Personal communication with Radian Corp. (May 20,1994); This engineering text was used
to help develop many of the costs analyzed in this EIA, especially for developing distillation
treatment equipment costs.

                                          7-20

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       722.3 Direct Labor Requirements for Operating Compliance Equipment

       The technical contractor estimated the annual labor hours required to operate
compliance equipment as the basis for assessing the annual operating and maintenance costs of
the pharmaceutical industry regulatory options.  On an FTE basis, the estimated annual labor
requirement for operating compliance equipment is 1.8 million hours per year.  Thus 889 FTEs
will be created annually for the maintenance of compliance equipment.  This value is assumed to
recur annually over the period of analysis (16 years).  The corresponding total annual estimated
payments to labor is $51.3 million (1990 dollars).
       722.4 Total Direct Labor Requirements

       Summing the three components yields the total direct labor requirements for complying
with the proposed pharmaceutical industry effluent guideline as represented by the selected
regulatory options (see Table 7-7).  On an FEE basis, the estimated total annual labor
requirement is 967 FTEs.  The corresponding total annual estimated payments to labor is $55.8
million (1990 dollars).  To the extent that these labor requirements manifest as new labor needs
in the U.S. economy, the 967 FTEs have the potential to offset employment losses that might
otherwise occur because of the rule.
       7.23 Estimating the Secondary (Indirect and Induced) Labor Requirement Effects

       In addition to direct labor effects, the pharmaceutical industry effluent guidelines might
also generate labor requirements through the indirect and induced effect mechanisms thereby
generating secondary employment.  The secondary effects associated with an economic activity
are analyzed by using multipliers.  Multiplier estimates generally vary with the industry in which
the direct economic activities are expected to occur and with the economic characteristics of the
location of the direct activities.
                                          7-21

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       A range of multipliers was used in this analysis to illustrate the possible aggregate
employment effects of the effluent guideline. A recent EPA study used multipliers ranging from
3.5 to 3.9 to calculate the possible indirect and induced employment effects of direct activity
investments in general water treatment and pollution control (EPA, 1993). A study of "clean
water investments" commissioned by the National Utility Contractors Association (NUCHA;
Apogee Research, Inc., 1992) documented total employment effect multipliers ranging from 2.8
to 4.0. Using the high and low values for these multipliers, the indicated aggregate employment
effects associated with the direct labor requirement of 967 FTEs would range from 2,708 to 3,868
FTEs.

       A more conservative assessment of these possible employment effects would recognize
that the three categories of labor requirements analyzed in Section 1.22 are likely to have
different indirect labor demand effects. In particular,  the direct labor demands for
manufacturing and installing compliance equipment result  from  additional economic activity in
those industries. Accordingly, it is reasonable  to expect that the additional economic activity in
manufacturing and installing equipment will  translate into  increased activity in the industries that
are linked to the direct effect industries and, hence, lead to additional labor demand in those
industries through the indirect effect mechanism.  In contrast, the  increased labor demand in the
pharmaceutical industry for operating compliance equipment does not result from increased
economic activity in that industry.  As a result, increased labor demand in the pharmaceutical
industry resulting  from the effluent guideline might not translate into increased labor
requirements in the industries that are linked to the pharmaceutical industry.  In this case, the
appropriate employment multiplier for the equipment-operations component of direct labor
requirements should exclude the indirect effect mechanism and include only the induced effect
mechanism. Multipliers cited in the NUCHA study referenced above suggest that a multiplier
based only  on the induced effect mechanism  might fall in the range of 2.4 to 2.9.  Using this
lower multiplier range for the equipment-operations component of direct labor requirements and
the higher,  2.8 to 4.0 range for the manufacturing  and  installation  components, the estimated
                                          7-23

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aggregate employment effects of the pharmaceutical industry effluent guideline would range from
2,35210 to 2,890U FTEs.

      Primary employment gains estimates might be high because the 967 FTEs per year that
are gained might not actually create new jobs. Many facilities and firms, even when they remain
viable after compliance with the guidelines might need to cut back on production.  These
potential cut-backs create slack time for the workers who might then divert their time towards
maintenance of the compliance equipment.  Because data do not exist to estimate  the number of
production hours, the number of production hour losses due to production line closures and
other production reductions cannot be estimated. It is, perhaps, more realistic to assume that
gains at  the facility level (for operating and maintaining pollution control equipment—889 hours)
do no more than offset similar losses in production hours. More realistic primary  gains are
therefore estimated at 78 FTEs.

      Thus the lower end of the employment gams range might not be low enough. In the
worst case, it is assumed that the lower end of the range for induced labor effects relating to the
manufacturing and installing of equipment (2.8) is applied, and only this  labor component is
counted as primary employment gains (78 FTEs). At the high end of the range, the primary
labor gains for all labor components are counted and the high-end multipliers are used (2.9 for
operating labor and 4.0 for manufacturing and installation). These assumptions produce
employment gains range between 218  and 2,890 FTEs.
7.3     NET EFEECT OF EMPLOYMENT LOSSES AND GAINS

       In the worst case, the primary employment gains (78 FTEs) are expected to partially
offset employment losses (91 FTEs).  Primary and secondary gains of between 218 and 2,890
FTEs are expected to offset to some extent the primary and secondary loss of 541 FTEs
estimated in Section 7.1. The net effect on employment therefore might range from a loss of 323
   1078 x 2.8 + 889 x 2.4.
   "78 x 4 + 889 x 2.9.
                                         7-24

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FTEs to a gain of 2,349 FTEs.  The net employment impact is negligible when compared to
national-level employment and will have no impact on national-level employment rates.

       Under the alternative regulatory scenario (in-plant steam stripping/distillation), the
number of losses are the same, but the number of gains are slightly higher because of the
somewhat greater expenditures on equipment and installation (see Appendix C). A total of 83
FTEs (annual) would be expected to be added as a result of equipment manufacturing
requirements.  A total of 13 FTEs (annual) would be expected to be added as a result of
installation needs and the number of FTEs for operation remain the same as in the selected
scenario. Thus, total gains under the alternative scenario would be 96 to 985 FTEs. Primary and
secondary gains would be 269 to 2,962 FTEs. Thus, the net effect of the alternative regulatory
scenario might range from a loss of 272 FTEs to a gain of 2,421 FTEs.
7.4    REFERENCES

Apogee Research, Inc., 1992.  A Report on Clean Water Investment and Job Creation.  Prepared
for National Utility Contractors Association, March 1992.
BEA, 1991a.  The 1982 Benchmark Input-Output Accounts of the United States. U.S. Department
of Commerce
BEA, 1991b. "Benchmark Input-Output Accounts for the U.S. Economy, 1982." In: Survey of
Current Business, July.
BEA, 1992. Regional Multipliers: A User Handbook for the Regional Input-Output Modeling System
(RIMSII). U. S. Department of Commerce, Washington, D.C.
OMB, 1992. Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs.
Circular A-94, Oct. 29,1992.
Peters and Timmerhaus,  1980. Plant Design and Economics for Chemical Engineers. Third
edition.
U.S. EPA.  1993. U.S. Environmental Protection Agency. Job Creation Fact Sheet.  Office of
Water, internal  document, February.
                                         7-25

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                                  SECTION EIGHT
                   ANALYSIS OF FOREIGN TRADE IMPACTS
       Pharmaceutical products are traded in an international market, with producers and buyers
located worldwide. Changes in domestic pharmaceutical production due to the effluent
guidelines might therefore affect the balance of trade.  Exports might decrease as previously
exported products are no longer manufactured, and imports might increase as domestic
purchasers seek new sources of Pharmaceuticals discontinued as a result of facility and/or
company closures.

       These foreign trade effects are the focus of this section of the EIA. The total change in
value of U.S. pharmaceutical exports resulting from the guidelines is estimated. The significance
of this change is  then scrutinized by comparing it with total value of current U.S. pharmaceutical
exports.  Ideally, the analysis would extend to consideration of changes in imports, as well as
additional export losses from facilities experiencing impacts short of closure, such as product line
closures.  Analysis of these issues, however, would require an international market model.  This
is beyond the scope of the current analysis.

       Section 8.1 presents the methodology used to estimate the change in the value of exports
and evaluate the significance of this impact.  Results of the analysis are presented in  Section 8.2.
8.1    METHODOLOGY

       For facilities expected to close that exported a portion of their pharmaceutical production
in 1990, the value of 1990 pharmaceutical exports is estimated. The estimate for each facility is
obtained directly from survey data:  the total value  of pharmaceutical shipments reported by the
facility is multiplied by the percentage of pharmaceutical shipments exported and these  values
are summed across closing facilities to obtain an estimate of the total value of U.S.
                                          8-1

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pharmaceutical exports no longer produced.  This value is then compared to the total value of
U.S. pharmaceutical exports produced in 1990.

       The analysis assumes that none of the decreased production of exported pharmaceutical
products is replaced by alternative U.S. products. This "worst-case" assumption is very
conservative and is likely to overestimate the reduction  in exports. If the impact on foreign trade
is not significant in this worst-case scenario, then more realistic scenarios would also indicate no
significant impacts. Likewise, increases in imports are assumed to be equivalent to the decline in
exports (consistent with the zero cost-passthrough assumption used in the facility- and firm-level
impact models). The existing balance of trade is then adjusted to reflect the increase in the
value of imports and decline in the value of exports. A comparison of pre- and post-regulation
trade balances will reveal the extent of the regulation's impact on the U.S. balance of trade.
8.2    RESULTS

       The impact of effluent guidelines on pharmaceutical exports and the U.S. balance of
trade is negligible. As discussed in Sections Five and Six, no facilities are expected to close as a
result of the selected regulatory options and only one firm/facility (a B/D indirect facility) is
expected to fail. As can be seen in Table 8-1, this firm has pharmaceutical  exports totaling $76
thousand.  The loss of these exports has virtually no effect on U.S. pharmaceutical exports,
which, according to the U.S. Department of Commerce, totalled $5.7 billion in 1991 (see  Section
Three). Results are the same under the alternative regulatory scenario.
                                           8-2

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                         TABLE 8-1

       LbSS IN FOREIGN SHIPMENTS FOR SELECTED
OPTIONS (Thousands of 1990 $): POSTCOMPLIANCE ANALYSIS
Facility
Subcategory
Exports
Lost
Total
Exports
%of
Total

A/C
B/D
$0
$0
$65,249
$9,175
0.00%
0.00%

A/C
B/D
$0
$76
$443,450
$431,834
0.00%
0.02%

A/C
B/D
$0
$0
$2,444
$846
0.00%
0.00%

TOTAL
$76
$952,998
0.01%
    * These numbers reflect those foreign shipments projected to
    remain following the baseline analysis.

    Note:
    1. Analysis assumes no foreign shipments are lost for certified
    facilities.
    2. Analysis excludes 12 facilities (1 A/C direct discharger,
    1 B/D direct discharger, 1 A/C indirect discharger, 8 B/D
    indirect dischargers, and 1 A/C zero discharger) because of
    lack of financial data.

    Source: ERG estimates.
                             8-3

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                                   SECTION NINE
                     REGULATORY FLEXIBILITY ANALYSIS
9.1    INTRODUCTION

       The Regulatory Flexibility Act requires the federal government to consider the impacts
on small entities (as defined in 13 CFR Part 121) as part of rulemaking procedures. The goal of
the analysis is to ensure that small entities potentially affected by a new regulation will not be
disproportionately burdened.  Small entities have limited resources, and it is the responsibility of
the regulating federal agency to avoid, if possible, disproportionately or unnecessarily burdening
such entities.

       The effluent guidelines and standards for the pharmaceutical industry will  affect how
small firms in this industry treat their wastewater.  Section 9.2 discusses the analyses that must be
undertaken according to EPA guidance; Section 9.3 presents the analyses required for an Initial
Regulatory Flexibility Analysis (IFRA), Section 9.4 presents a profile of the affected small firms;
and Section 9.5 determines the aggregate and firm-level impacts on small firms.
9.2    SUMMARY OF EPA GUIDELINES ON RFA REQUIREMENTS

       EPA guidelines now require EPA Offices to perform Regulatory Flexibility Analyses
(RFAs) for regulations that have any effect on any small entities. Formerly, EPA determined
whether an RFA should be performed by determining whether the rule  in question had a
significant economic impact on a substantial number of small entities. When using this approach,
EPA spent time trying to determine whether the rule did have  a significant impact on a
substantial number of small entities.  With the new approach, EPA can  bypass much of this
preliminary analysis and proceed to address the impacts on the affected entities.

       EPA's approach is divided into two stages:  an Initial Regulatory Flexibility Analysis
(IRFA), performed for a proposed rule, and a Final Regulatory Flexibility Analysis, (FRFA),
                                          9-1

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performed for a final rule.  This EIA is being prepared for a proposed rule, so an IRFA must be
performed at this time.


       The IRFA is divided into six requirements:


       •      Explain why the Agency is considering taking action.

       •      State succinctly the objectives of, and legal basis for, the proposed rule.

       •      Describe and, where feasible, estimate the number of small entities to which the
              proposed rule will apply.

       •      Describe the projected reporting, recordkeeping, and other compliance
              requirements of the proposed rule, including an estimate of the classes of small
              entities that will be subject to the requirements and the type of professional skills
              necessary for preparation of reports or records.

       •      Identify, to the extent possible, all relevant federal rules that might duplicate,
              overlap, or conflict with the proposed rule.

       •      Describe any significant alternatives to the proposed rule that accomplish the
              stated objectives of applicable statutes while minimizing the rule's economic
              impact on small entities.


       Specific analyses suggested by the guidelines for characterizing impacts include the
following:
              A closure analysis (at the firm level) using ratio analysis (see Section Six).  To
              characterize impacts for this IRFA, this section summarizes the information in
              Section Six, comparing the relative post-regulatory health of small firms with that
              of larger firms.

              A discounted cash flow analysis  examining the consequences of the annual costs
              of compliance.  This analysis investigates the impacts on cash flow by determining
              the present value of total compliance costs at a firm as a percentage of the
              present discounted value of cash flow (in this EIA, net income is used as a more
              conservative estimate of income—see Section Five for a further discussion).

              A socioeconomic analysis, if the number of affected firms leads to changes in:
              employment conditions,  income, social service expenditures, tax revenues, and/or
              balance-of-trade levels.
                                            9-2

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       The first two items are discussed in Section 9.5. Many of the socioeconomic impacts are,
however, expected to be minimal because of the very small number of firms affected by the
regulation (a small subset of the pharmaceutical industry only).  However, potential impacts on
communities are discussed in Section Seven and distributional impacts, including the potential for
increases in payments by state and federal governments for Medicare and Medicaid, are
discussed in Section Ten.
9.3    IRFA INFORMATION REQUIREMENTS
       9.3.1   Reasons for Taking Action and Objectives of and Legal Basis for the Proposed
              Rule
       The Federal Water Pollution Control Act Amendments of 1972 established a
comprehensive program to "restore and maintain the chemical, physical, and biological integrity
of the Nation's waters" (Section 101[a]).  To implement the Act, the U.S. EPA is required to
issue effluent limitations guidelines, pretreatment standards, and new source performance
standards for industrial dischargers.
       932  Estimates of the Affected Population of Small Businesses

       A basic step in conducting an IRFA is to estimate the affected population. Small firms
are defined in 13 CFR Part 121 either by their employment size or their revenues. In SIC 2833
and 2834, small  firms are defined as those employing 750 or fewer persons; in SIC 2835 and
2836, those employing 500 or fewer persons are defined as small.  For simplicity, this IRFA
designates all pharmaceutical firms as small if they employ fewer than 750 persons.  For greater
awareness of where impacts are occurring, this analysis further breaks down small firms into
employment groups. These groups are as follows:

       •     0-18 employees
       •     19-99 employees
                                          9-3

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       •      100-499 employees
       •      500-750 employees
       •      > 750 employees

       This analysis therefore will consider all categories except the > 750 category as small for
the purposes of identifying the affected small business population.

       The numbers of firms in each grouping are presented in Table 9-1. These numbers
reflect all firms in the survey universe including those expected to fail in the baseline. As the
table shows, out of 1901 firms in the survey universe, 76 percent are small firms.2  The largest
percentage of firms are in the 100-499 employees size group (37 percent of all firms in the survey
universe).
       9.3.3 Projected Recordkeeping and Reporting Requirements

       The proposed effluent guidelines for the pharmaceutical industry are revisions to existing
effluent guidelines, thus most recordkeeping and reporting requirements are not incremental to
existing guidelines. The exception is new monitoring requirements.  The costs of monitoring
have been estimated by EPA's technical contractor and are reported on a per-facility basis (EPA,
1995).  Monitoring costs to industry total $9.0 million annually and average 15 percent of the
total annual compliance cost for the selected options (computed as a median of firm-by-firm
percentages among firms incurring compliance costs).  Costs for monitoring by size of firm are
shown in Table 9-2. As the table shows, large firms incur the largest proportion of monitoring
costs (61 percent of total monitoring costs).  Monitoring costs are a larger share of total annual
    1This number differs from the number of firms analyzed in Section Six because three firms
with insufficient data were dropped from the Section Six analysis.
    2The number of small firms might be overestimated. Because of data limitations in the
Section 308 survey, firm size was computed on the basis of total employment at each firm's
facilities plus 10 percent of that total facility employment (see Section Seven for the method used
for computing nonfacility employment at firms).  Many firms, however, could own other
nonpharmaceutical facilities or other pharmaceutical facilities that are not covered by the
proposed effluent guidelines.  Thus,  total employment at one firm could be underestimated.
                                           9-4

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                                        TABLE 9-2

              INCREMENTAL RECORDKEEPING AND REPORTING COSTS
Employment
Size of Firm
0-18
19-99
100 - 499
500 - 750
>750
# Firms with
Nonzero
Compliance
Costs
9
26
47
17
40
Total
Monitoring
Costs
$105,215
$984,005
$1,623,545
$844,635
$5,478,385
% of Total
Industry
Monitoring
Costs
1%
11%
18%
9%
61%
Total Pretax
Compliance
Costs*
$527,596
$8,025,577
$11,725,311
$9,668,052
$83,456,895
Monitoring Costs
as % of
Compliance Costs**
1.2%
16.7%
25.4%
19.8%
10.2%

All Firms <= 750
All Finns
99
139
$3,557,400
$9,035,785
39%
100%
$29,946,536
$113,403,432
20.0%
L 14.8%
* Pretax compliance costs are ammalized at 11.4%.
** Percentage calculated as the median of monitoring costs divided by compliance costs for each firm in
the group rather than average monitoring costs divided by average compliance costs. Analysis does
not include firms with zero compliance costs.

Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report.

Source: ERG estimates based on Radian Corp. estimates of capital and operating costs for pollution control
equipment (including operating costs).
                                                9-6

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compliance costs at small firms (20 percent) than at large firms (10 percent). The highest
proportion (25.4 percent) of monitoring costs as a percentage to compliance costs is experienced
among firms in the 100-499 employees size group. In general, however, small firms do not
appear to be disproportionately affected by recordkeeping and reporting requirements compared
to large firms, since small firms incur only 39 percent of total industry monitoring costs yet make
up 76 percent  of the affected industry.  Monitoring costs as a percentage of total compliance
costs are much lower (6.7 percent for all firms) under the alternative regulatory scenario (steam
stripping/distillation) because monitoring costs do not change but compliance costs are greater
(see Appendix C).
       9.3.4  Other Federal Requirements

       EPA is aware of no federal rules that duplicate, overlap, or conflict with the proposed
effluent guidelines for the pharmaceutical industry.
       9.3.5  SigniGcant Alternatives to the Proposed Rule

       For A/C direct dischargers EPA did not select the lowest-cost option because incremental
impacts from BAT-A/C#2 compared to BAT-A/C#1 were negligible. For B/D direct
dischargers, EPA determined that impacts from more stringent options would not be measurably
greater than those from the least costly option. However, the Agency also concluded that
existing levels of pollutants of concern were sufficiently low in this group's discharges that the
selection of the lowest-cost option not only guaranteed the lowest possible impacts on small firms
but also still met the stated objectives of the Clean Water Act. A no-action alternative would
not meet the stated objectives of the Act.

       For indirect dischargers EPA selected the least costly alternatives under consideration
short of not regulating these  discharges.  These alternatives are considered the least expensive
option for indirect dischargers (small or large) that meet the stated objectives of the Clean Water
Act (the no-action alternatives would not meet these objectives).

                                           9-7

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       Because some firms in the smaller size groups already achieve a level of pollution control
equivalent to that in the proposed effluent guidelines and because impacts overall are low for all
size groups (see discussion in Section 9.5) impacts, while slightly more noticeable among certain
small firms, are not considered excessively disproportionate.

       Thus the Agency believes the stated objectives of the Clean Water Act are met with this
proposed rule, while the impacts to small firms have been considered, where possible.
9.4   PROFILE OF SMALL PHARMACEUTICAL FIRMS

      Tables 9-3 through 9-5 provide general information about the financial condition of small
pharmaceutical firms in the Section 308 survey as compared to large firms (all firms are
considered here, not just the financially healthy firms). As Table 9-3 shows, median total assets
and liabilities rise with size, as does median net income.  In general, small firms tend to have
lower ROA than large firms, although the 500 to 750 employees size group has a considerably
higher ROA than firms with over 750 employees. The poorest performing groups are the 19 to
99 employees and the 100 to 499 employees size groups, which have a median ROA of 4 percent.

      Predictably, average pharmaceutical costs and revenues tend to rise with the size of the
firm (see Table 9-4).  Pharmaceutical revenues comprise  60 percent of total income in large
firms, whereas  in small firms the proportion rises as high as 87 percent in the 500 to 750
employees size groups, indicating that these firms hold fewer diverse interests than  firms in other
size groups.  A diversity of holdings can minimize impacts from the proposed effluent guidelines
for the pharmaceutical industry.  The less diverse holdings among the 0 to 18 and the 500 to 750
employees size groups make these  firms somewhat more  vulnerable to impacts from the
proposed effluent guidelines.

      Table 9-5 profiles values of shipments and exports by size of firm. The proportion of
shipments exported shows no clear tendency to increase with size, with the 19 to 99 employees
size group averaging the highest percentage of exported shipments (4 percent exported), although
                                           9-8

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                             TABLE 9-3

           PROFILE OF PHARMACEUTICAL FIRMS BY SIZE:
                 FINANCIAL INDICATORS ($0001990)
Employment
Size of Firm
0-18
19-99
100 - 499
500 - 750
>750
Median Total
Assets
$892
$8,755
$72,347
$268,217
$823,484
Median Total
Liabilities
$294
$6,921
$34,549
$48,406
$268,484
Median
Net Income
$42
$282j
$1,926
$21,054
$136,560
Median
BaseROA
6%
4%
4%
15%
10%

All Firms <= 750
All Firms
$54,355
$95,340
$17,259
$34,549
$882
$2,469
5%
5%
Note: Analysis excludes eight firms because of lack of financial data.

Source: Section 308 Pharmaceutical Survey.
                                9-9

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                                  TABLE 9-4

               PROFILE OF PHARMACEUTICAL FIRMS BY SIZE:
             PHARMACEUTICAL COSTS AND REVENUES ($0001990)
Employment
Size of Firm
0-18
19-99
100-499
500 - 750
>750
Median
Pharmaceutical
Costs
$368
$5,961
$20,050
$58,744
$166,763
Median
Pharmaceutical
Revenues
$898
$6,217
$24,665
$159,698
$367,568
Median
Total
Revenues
$1,068
$12,790
$60,263
$326,652
$911,056
% Pharmaceutical
Revenues to
Total Revenues*
78%
50%
58%
87%
60%

All Finns <= 750
All Firms
$9,210
$25,281
$21,304
$39,768
$46,595
$80,189
64%
64%
Footnotes:
* Median for each group is based on percentage calculated for each firm in the group rather than
median pharmaceutical revenues divided by median total revenues.

Note: Analysis excludes seven firms because of lack of financial data.

Source: Section 308 Pharmaceutical Survey.
                                    9-10

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                            TABLE 9-5

        PROFILE OF PHARMACEUTICAL FIRMS BY SIZE:
              SHIPMENTS AND EXPORTS ($0001990)
Employment
Size of Firm
0-18
19-99
100 - 499
500 - 750
>750
Median
Exports
$0
$184,594
$48,321
$897,835
Median
Value of
Shipments
$611,594
$7,244,567
$24,485,315
$120,707,495
$2,395,200] $242,835,603
Exports as
% of Value
of Shipments*
0.0%
4.0%
0.2%
1.1%
1.1%

All Finns <= 750
All Finns
$75,716
$104,860
$15,155,041
$33^622,023
0.8%
1.0%
Footnote:
* Median for each group is based on percentage calculated for each firm in the
group rather than median exports divided by median shipments.

Note:
1. Analysis excludes three firms because of lack of financial data.
2. Analysis excludes finns with certified facilities.

Source: Section 308 Pharmaceutical Survey.
                                    9-11

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total value exported does tend to increase with size (with one exception).  On average, exports
are 0.8 percent of shipments at small firms, which is nearly the same as to that for large firms.

       Table 9-6 presents the results of the baseline firm failure analysis by firm size. Small
firms tend to be projected to fail in the baseline disproportionately relative to large firms.
Although only 32 percent of small firms are considered likely to fail in the baseline, 45 out of a
total 54 baseline firm failures are expected among small firms, which is over 80 percent of
projected baseline failures.  The group with the largest proportion of baseline firm failures is the
19 to 99 employees size group, in which nearly 50 percent of the group is projected to fail.
Firms in the 100 to 499 employees size group also are somewhat weaker than firms in the other
size groups (32 percent of the group is expected to fail). The healthier firms tend to be those in
the very smallest size category and the two largest size categories (500 to 750 employees and
more than 750 employees).  This pattern of financial health also can be seen in Table 9-3, which
shows these size groups with the highest median ROA.
9.5    IMPACTS ON SMALL PHARMACEUTICAL FIRMS

       Two measures of impact are used to determine whether disproportionate impacts are
occurring among small firms:  the firm failure analysis and the discounted net income analysis.
These analyses are discussed below.
       9.5.1 Firm Failure Analysis

       In Section Six, the EIA examined firm-level impacts by comparing postcompliance
financial ratios to industry benchmarks and calculating the postcompliance change in firm-level
profitability. As discussed in this section, three firms are predicted to experience significant
impacts as a result of the proposed effluent guidelines under the selected options.  These firms
would be at risk of financial failure, and, at the very least, would experience difficulty obtaining
financing for wastewater treatment capital investments. (The two firms in question have fewer
than 750 employees). One firm has fewer than 18 employees, one firm has 19 to 99 employees,
                                          9-12

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                          TABLE 9-6

         BASELINE FIRM FAILURES BY SIZE OF FIRM
Employment
Size of Firm
0-18
19-99
100 - 499
500 - 750
>750
Total
'Number
of Firms
17
33
68
24
45
Financially
Healthy Firms
#of
Firms
14
17
46
20
36
%of
Groups
82.4%
51.5%
67.6%
83.3%
80.0%
Firms Likely
to Fail
#of
Firms
3
16
22
4
9
%of
Groups
17.6%
48.5%
32.4%
16.7%
20.0%

All Finns <= 750
All Finns
142
187
97
133
68.3%
71.1%
45
54
31.7%
28.9%
Note:
1. Analysis excludes three firms because of lack of financial data
2. Analysis assumes that firms with certified facilities pass baseline.

Source: ERG estimates.
                                   9-13

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and one firm has over 750 employees.  Thus, two-thirds of the significant firm impacts are among
small firms.  Overall, very few small firms are affected.  Out of 97 small firms in the
postcompliance analysis, the 2 failing small firms represent only 2 percent of all small firms.  This
result is the  same under the alternative (in-plant steam  stripping/distillation) regulatory scenario.

       The EIA also examined the change in profitability among affected firms as a result of the
proposed effluent guidelines. Change in profitability was measured in Section Six as the change
between baseline and postcompliance  annual ROA A change of greater than 5 percent was
identified as a  significant impact.  As seen in Table 9-7, which breaks out the profitability results
reported in Section Six into size categories, 14 out of 15 of the firms experiencing substantial
declines in ROA are considered small firms, which is 14 percent of all small firms in the
postcompliance analysis (97 small firms, when certifiers are included). Nearly all firms with
declines in ROA greater than 5 percent are in the 19 to 99 or 100 to 499 employees size group.
Only eight small firms (8 percent) would  experience a decline of more than 20 percent.  Under
the alternative regulatory scenario (in-plant steam stripping/distillation), 18 small firms (19
percent of all small firms) would experience a decline in ROA of more than 5 percent and 9
firms (9 percent) would experience a decline of more than 20 percent (see Appendix C).
       9.5.2 Discounted Net Income Analysis

       Table 9-8 shows the distribution of present discounted value of compliance costs as a
percentage of the present discounted value of net income (NPV) by firm size.

       Except in the 19 to 99 employees size category, the total present value of compliance
costs as a percentage of NPV is, on average, smaller among small firms.  It is not surprising that
the 19 to 99 employees size group is more heavily affected since it is one of the weaker groups
financially and has the highest median compliance costs of all small firm groups.  In most cases,
the present value of compliance costs is less than 1 percent, on average, of NPV, computed on a
firm-by-firm basis.  Furthermore, this  percentage is lower for small firms (0.04 percent) than for
large firms (025 percent). Under the alternative regulatory scenario (in-plant steam stripping/
                                          9-14

-------




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-------
                         TABLE 9-8

PRESENT VALUE OF COMPLIANCE COSTS AS A PERCENTAGE
  OF PRESENT VALUE OF POSTCOMPLIANCE NET INCOME
Employment
Size of Firm
0-18
19-99
100-499
500 - 750
>750
Median
Compliance
Costs (PV)
$0
$385,101
$3,324
$54,327
$1,160,172
Median
Postcompliance
Net Income (PV)
$427,787
$6,883,179
$58,170,339
$432,987,636
$1,432,475,847
Compliance
Costs as %
of Net Income*
0.00%
2.11%
0.01%
0.01%
0.25%

All Finns <= 750
All Finns
$48,836
$84,814
$46,148,682
L_ $102,982,098
0.04%
0.06%
* Median for each group is based on percentage calculated for each firm in
the group rather than median compliance costs divided by median
postcompliance net income.

Note:
1. Analysis excludes three firms because of lack of financial data.
2. Analysis excludes all firms with certified facilities.
3. Analysis includes only those firms that pass both the baseline and
postcompliance analyses.

Source: ERG estimates.
                                 9-16

-------
distillation scenario), small firms have compliance costs averaging 0.1 percent of NPV and large
firms, 0.5 percent (see Appendix C).

       The above analyses indicate that although the small firms do bear a large portion of the
firm failures, these major impacts occur among a very small proportion (2 percent) of small
firms. Additionally, the present value of compliance costs compared to the present value of net
income are expected to be smaller, on average, among small firms than among large firms.
Therefore, overall, EPA finds that impacts on small firms are not disproportionate to those on
large firms under either the selected or alternative regulatory scenarios.
9.6    REFERENCES
U.S. EPA. 1995. U.S. Environmental Protection Agency. Development Document for Proposed
Effluent Limitations, Guidelines and Standards for the Pharmaceutical Manufacturing Point
Source Category. Washington, DC, February.
                                         9-17

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                                    SECTION TEN
                   ANALYSIS OF DISTRIBUTIONAL IMPACTS
       Up to this point, the EIA has been conducted assuming zero cost passthrough (i.e., that
facilities cannot raise pharmaceutical prices in an effort to recoup regulatory costs). As pointed
out in Section Three, however, the assumption that pharmaceutical manufacturers act as pure
price takers in perfectly competitive markets probably would not hold true in most cases.  Many
markets for specific drugs are characterized by monopolistic or oligopolistic conditions in which
manufacturers exercise considerable control over drug prices.  The zero cost passthrough model
was employed nonetheless because product-specific demand elasticity data are lacking, and
because this assumption tends to overstate facility impacts rather than understate them (i.e., it
provides for a worst-case scenario of facility- and firm-level impacts).

       Conversely, the assumption that facilities will bear the entire cost of incremental
regulatory costs might understate the economic impacts on consumers of Pharmaceuticals. If the
more realistic assumption that manufacturers will raise pharmaceutical prices in response to
increased regulatory costs is employed, then one needs to consider who will be affected by these
price increases and whether higher drug prices will affect certain demographic groups more than
others.  For example, the elderly account for very large portion of all drug use. This group,
therefore, might be particularly hard hit by increases in drug prices.  It might be reasonable to
assume that the uninsured population will also be particularly hard hit by increases in drug prices
because they have no immediate financial recourse and might have to make difficult decisions
between pharmaceuticals and other daily necessities. Ultimately, state and federal governments
might bear the costs of increased drug prices through Medicaid, Medicare, and other health
insurance programs.

       This section first investigates the extent to which drug prices could rise assuming perfectly
inelastic demand. Given perfectly inelastic demand, the EIA calculates the rise in drug prices as
the ratio of total compliance costs to total cost of pharmaceutical production in the affected
facilities and in the pharmaceutical industry as a whole (e.g., if compliance cost are 1 percent of
                                          10-1

-------
production costs, then drug prices are assumed to rise by 1 percent). The analysis then
investigates the impacts of increased drug prices on various demographic groups such as the
elderly, the population living under the poverty level, disadvantaged minorities, the uninsured,
and state and federal governments. In the absence of any quantitative data on price elasticities
and existing drug prices, the discussion is necessarily qualitative in nature.  The discussion
assumes that pharmaceutical manufacturers are able to pass through all of the increased
regulatory costs associated with the various wastewater treatment options.
10.1   INCREASES IN DRUG PRICES

       Table 10-1 shows compliance costs as a percentage of total pharmaceutical costs by
regulatory option. The average ratio for each facility subcategory ranges from 0.2 to 3.4 percent.
For all the selected regulatory options, the ratio of compliance costs to total pharmaceutical costs
is 1.6 percent. Table 10-1 also shows the distribution of the number of facilities by compliance
costs to pharmaceutical costs.  As can be seen, 41 facilities (20 percent of all facilities in this
analysis) would incur compliance costs greater than 1 percent of total pharmaceutical production
costs, and three facilities (1 percent of all facilities) would incur compliance costs greater than 10
percent of total pharmaceutical production costs.  A little over one quarter of all  facilities would
experience no increase in total pharmaceutical production costs as a result of the effluent
guidelines. Under the alternative regulatory scenario (steam stripping/distillation) the percentage
of compliance costs to total pharmaceutical production costs would average 2.5 percent (see
Appendix C).

       Reliable data on total U.S. pharmaceutical production costs are not available. Thus, the
EIA cannot precisely compute compliance costs as a percentage of total U.S. pharmaceutical
production costs.  Nevertheless, it is clear that if worst-case compliance costs average 1.6 percent
of the total pharmaceutical costs of the regulated sector, this ratio would be significantly lower if
compliance costs  were compared to production costs for the entire industry.
                                           10-2

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10.2   IMPACTS ON SPECIFIC DEMOGRAPHIC GROUPS

       Although in the aggregate, the potential overall increase in drug prices attributable to
increased regulatory costs is minuscule, the potential increase in specific drug prices might have a
significant impact on certain demographic groups.  As noted above, three facilities will
experience compliance costs in excess of 10 percent of total pharmaceutical manufacturing costs.
If the drugs produced by these facilities are unique (i.e., protected from direct competition either
through patents or a lack of close substitutes) then these facilities might be able to increase the
price of their drugs in order to offset compliance costs.  Table 10-2 presents the result of an
examination of the products produced by facilities that incur compliance costs greater than 10
percent of total pharmaceutical production costs and presents which groups predominantly use
the types of products made at these facilities.

       Because of confidentiality, the name or type of drug is not presented. The unknown
category deals with products that might be inputs to drugs rather than drugs themselves (i.e.,
they are primarily reported as chemical names).

       As Table 10-2 shows, children (including infants and adolescents), women, and the elderly
are likely to be the major consumers of many of these products.  According to Health Insurance
Association of America (HLAA, 1991), the groups least likely to have health insurance are
hispanics (312 percent of whom lack health insurance), young adults 16-24 years of age (203
percent of whom lack health insurance), young adults 25-34 years of age (173 percent of whom
lack health insurance), and African Americans (17.5 percent of whom lack health insurance);
African Americans, hispanics, and children are most likely to be covered by government
insurance, and African Americans, hispanics, and the elderly are least likely to have insurance
related to employment. Government insurance programs tend to spend less on drugs and other
medical nondurables than do private insurers, according to this same source, and about 93
percent of people with work-related medical insurance have some type of drug insurance.

       When all these factors are accounted for, it appears that those who lack any health
insurance, those who are covered by government insurance, and those who are covered by
nonwork-related medical insurance might be least  likely to have drug coverage.  This group

                                          10-4

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would include:  hispanics, African Americans, the elderly, young adults (16-34), and children
(under 16).  When the predominant consumers of the products expected to be affected by
potentially sizeable cost increases are compared to the groups most likely to lack drug insurance,
young adult women, children, and the elderly are likely to be the most heavily affected by
potential cost increases, if such increases can be passed through to consumers.

       Because, on average, any potential price increases are likely to be very low (1.6 percent
on average), impacts on mass consumers of drugs such as HMOs, governments, and, indirectly,
third-party insurers, should be minimal.
10.3    REFERENCES
HIAA, 1991. Source Book of Health Insurance Data.  Health Insurance Association of America.
Overton, V. Demographics of the Major Users of Selected Drugs. Memorandum dated August
8,1994 (confidential business information).
                                          10-6

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                                  SECTION ELEVEN
                   ANALYSIS OF IMPACTS ON NEW SOURCES
        The selected options for new sources are NSPS-A/C#1, NSPS-B/D#1, PSNS-A/C#1, and
 PSNS-B/D#1. In all cases,  the requirements for new sources are more stringent than those for
 existing sources.  However,  the difference in cost between new source requirements and existing
 source requirements for typical facilities are relatively small when compared to the average
 facility costs of production.  In most cases, existing facilities would be required to retrofit in-plant
 steam stripping systems, whereas new sources would have to install in-plant steam
 stripping/distillation systems. Because designing in pollution control equipment in a new source
 is typically less expensive than retrofitting the same equipment in an existing source, the cost
 differential between the selected requirements for existing sources and those higher existing
 source options that are technically equivalent to new source requirements should be an upper
 limit on the differential annual cost faced by new sources. Where this differential is not
 substantial relative to the typical costs of doing business in this industry, no significant barrier to
 entry is likely to exist.

       The average per-facility compliance costs were investigated to determine what the cost
 differentials would be between proposed new source and existing source requirements.  The
 average per-facility cost differentials ranged from about a $34,000 to  a $590,000 difference (for
 A/C direct dischargers), depending on the type of facility (see Table 11-1). The maximum
 $590,000 difference generates the highest percentage of compliance cost differential to
 Pharmaceuticals manufacturing cost—about 1.4 percent of total manufacturing costs and about
 3.0 percent of pharmaceutical manufacturing costs.  Since this cost differential is likely to be less
 than that assumed here, this small premium estimated to be paid by new sources is not likely to
 have much impact on the decision to enter the  market. Furthermore, these same options, when
 applied to existing sources, were found to have nearly identical impacts on existing sources as the
selected options for existing  sources. Thus no significant barriers to entry are estimated to result
from the proposed new source requirements.
                                          11-1

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       Under the alternative regulatory scenario (in-plant steam stripping/distillation) only BAT-
B/D is less stringent than requirements for new sources.  The cost differential between BAT and
NSPS requirements is estimated to be $53 thousand, or about 0.1 percent of pharmaceutical or
total manufacturing costs.
                                         11-3

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             APPENDIX A

ASSUMPTIONS USED OR CONSIDERED FOR USE
   IN THE COST ANNUALIZATION MODEL
                 A-l

-------
                                   APPENDIX A
              ASSUMPTIONS USED OR CONSIDERED FOR USE
                   IN THE COST ANNUALIZATION MODEL
A.1    MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)

       The cost annualization model presented in Section Four is based on an assumption that
firms will use the Modified Accelerated Cost Recovery System (MACRS) to depreciate their
pollution control equipment for tax purposes. The Internal Revenue Service Tax Code requires
firms to use either the MACRs depreciation method or a straight-line method to depreciate
assets that were put into service after December 31,1986. MACRS, however, offers companies
an advantage over the straight line method, because a company's income might be reduced under
MACRS by a greater amount in the early years when the time value of money is greater. Table
A-l illustrates the advantage of using MACRS.  Although the absolute amount depreciated
under the straight line method and MACRS is equivalent ($614,487), MACRS provides a $9,745
benefit (in present value) because of the timing differences in writing off the investment. The
example in Table A-l uses a midyear convention for putting the equipment into operation, which
assumes only 6 months of depreciation in the first year (as well as only 6 months in the last
year).
A3.    TIMING

       The second assumption used in the cost annualization model is one of timing.  Although,
the midyear convention frequently is used when calculating depreciation (as was done above), it
is not appropriate for the analysis in Section Four. Approximately one year would be required to
build and install most of the equipment considered in the regulatory alternatives. Additional
time might be required for design, permitting, and site preparation. The cost annualization
model, therefore, assumes a 1-year delay from the capital expenditure to the beginning of
operation. As shown in Table A-2, the capital expenditure is listed in Year 1, but depreciation
                                        A-3

-------
                                 TABLE A-l

               COMPARISON OF STRAIGHT LINE DEPRECIATION VS.
            MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)
Capital Cost (Line A): $614,487
Discount Rate: 1 1.4%
Equipment Lifetime (Line B): 15
Marginal Tax Rates:
Federal 34.0%
State
Overall (Line C)
1


Year

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
Sum
Present Value[a]


2
Annual
Depreciation
(MACRS)
(Line A* 0.05)
$30,724
$58,376
$52,539
$47,315
$42,584
$38,283
$36,255
$36,255
$36,316
$36,255
$36,316
$36,255
$36,316
$36,255
$36,316
$18.127
$614,487
$328,531
6.8%
40.8%
3
Annual
Depreciation
(Straight-Line)
((Line A/Line B)/2)
$20,483
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$20.483
$614,487
$304,615


4

Tax Shield
(MACRS)
(Line C* Col 2)
$12,520
$23,788
$21,409
$19,281
$17,353
$15,600
$14,774
$14,774
$14,799
$14,774
$14,799
$14,774
$14,799
$14,774
$14,799
$7.387
$250,403
$133,876


5

Tax Shield
Straight-Line
(Line C* Col 3)
$8,347
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$8.347
$250,403
$124,131
Net benefit of using MACRS v.
straight line (Col 4-Col 5) ($year 1)
$9,745
                                      A-4

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                               A-5

-------
and annual O&M costs are not listed until Year 2 (assumed to be the first full year of
operation).1 The 1-year delay also changes each year's depreciation rates (see column 2).
A3    DERIVATION OF DEPRECIATION RATES

       Table A-3 shows the derivation of depreciation rates used in the cost annualization
model. The calculation uses the assumption that a 150 percent declining balance (DB) method
(MACRS) is used, switching to a straight-line  method in Year 5 as allowed by Section 168(b)(2)
of the Internal Revenue Code. The switch point is determined by the year in which depreciation
calculated by the straight-line method equals or exceeds that determined by the declining balance
method.  More in-depth information on how to calculate a MACRS depreciation rate can be
found in the U.S. Master Tax Guide (Commerce Clearinghouse, Inc., 1991).
A.4    AVERAGE STATE TAXES

       The cost annualization model uses an average state tax rate (see Section Four).  State
corporate income taxes are presented in Table A-4.  As the table shows, the average rate over all
states is 6.75 percent.
AJS    ADDITIONAL CONSIDERATIONS

       The cost annualization model does not consider how the facility will raise the capital to
finance the new pollution control requirements. A facility could finance its investment through a
bank, take money out of working capital, or issue a corporate bond.  In any case, the present
value analysis assumes a cost to the facility of 11.4 percent (the discount rate) to use the money,
whether that amount is paid as interest or is the opportunity cost of the internal funding.
    1 Assuming the equipment goes into service midway through the first year, the annualized cost
would decrease slightly because a 5-percent depreciation of the capital investment would more
than exceed a half year of O&M expenses.

                                          A-6

-------
                                               TABLE A-3

                            CALCULATION OF MACKS DEPRECIATION RATES
Assumptions:
       1. Property goes into service at beginning of year
       2. 150% double declining balance (DB) method (MACRS)
       3. 15-year property
       4. Assume $10,000 unadjusted basis
       5. Columns 4 and 7 switch to straight-line in Year 5
Year
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Sum
Years Remaining Straight-line 150% DB Rate
At Beginning Rate On Adjusted Baas
Of Year 0/Col 2) (I/Col 2 * 15)

15
14
13
12
11
10
9
8
7
6
5
4
3
2
1

0.00%
6.67%
7.14%
7.69%
833%
9.09%
10.00%
11.11%
12.50%
14.29%
16.67%
20.00%
25.00%
33.33%
50.00%
100.00%

0.00%
10.00%
10.71%
11.54%
12.50%
9.09%
10.00%
11.11%
12.50%
14.29%
16.67%
20.00%
25.00%
33.33%
50.00%
100.00%

Annual
Depreciation[a]

$1,000
$964
$927
$889
$565
$565
$565
$565
$565
$565
$565
$565
$565
$565
$565
$10,000
Adjusted Basis
atYear£nd[b]
$10,000
$9,000
$8,036
$7,109
$6,220
$5,655
$5,089
$4,524
$3,958
$3,393
$2,827
$2,262
$1,696
$1,131
$565
$0

150% DB Rate
On Unadjusted
Basis[c]
(Col 5/510,000)

10.00%
9.64%
9.27%
8.89%
5.65%
5.65%
5.65%-
5.65%
5.65%
5.65%
5.65%
5.65%
5.65%
5.65%
5.65%
100.00%
[a] Ex: Year 1 = Year 0 in Col 4* Year 1 in Col 6.
[b] Ex: Year 2= Year 1 in Col 6-Year 2 in Col 5
[c] Equivalent to column 2 in Table 4-2.
                                                   A-7

-------
                       TABLE A-4

            STATE CORPORATE INCOME TAXES
State
Alabama
Alaska
Arizona
Arkansas
California
Colorado
Connecticut
Delaware
Florida
Georgia
Hawaii
Idaho
Illinois
Indiana
Iowa
Kansas
Kentucky
Louisiana
Maine
Maryland
Massachusetts
Michigan
Minnesota
Mississippi
Missouri
Montana
Nebraska
Nevada
New Hampshire
New Jersey
New Mexico
New York
North Carolina
North Dakota
Ohio
Oklahoma
Oregon
Pennsylvania
Rhode Island
South Carolina
South Dakota
Tennesee
Texas
Utah
Vermont
Virginia
Washington
West Virginia
Wisconsin
Wyoming
Average:
Corporate
Income Tax
5.00%
9.40%
9.30%
6.00%
9.30%
5.00%
11.50%
8.70%
5.50%
6.00%
6.40%
8.00%
4.00%
4.50%
12.00%
6.75%
8.25%
8.00%
8.93%
7.00%
9.50%
2.35%
9.80%
5.00%
5.00%
6.75%
7.81%
0.00%
8.00%
9.42%
7.60%
9.00%
7.00%
10.50%
8.90%
6.00%
6.60%
12.25%
9.00%
5.00%
0.00%
6.00%
0.00%
5.00%
8.25%
6.00%
0.00%
9.30%
7.90%
0.00%
6.75%
Basis for States
With Graduated
Tax Tables
(Earnings)

$90,000+

$100,000+






$100,000+

Plus Excise Tax

$250,000+

$250,000+
$200,000+
$250,000+




$10,000+


$50,000+



$lM21ion+


$50,000+
Based on Stock Value









$250,000+






Sources:   Fortune Magazine, 1991;
         State Tax Handbook, 1991.
                            A-8

-------
According to current tax law, if the facility finances the investment using debt, the associated
interest expenses can be deducted, thereby reducing taxable income. The tax shield on the
interest payments thus would reduce the annualized cost of compliance. In contrast, the
opportunity cost of using working capital is not available.  Table A-2 illustrates the effect of 100-
percent debt financing.  In this case, the annualized compliance cost would drop by
approximately 4 percent due to tax shields on the interest payments. To maintain a conservative
cost estimate, tax shields on interest payments (Column 10) are not considered in the cost
annualization model. If a facility used 100 percent debt financing, the present value of
incremental costs would be further reduced, in the case illustrated, by $31,800.

       A final consideration is Section 169 of the Internal Revenue Code which provides the
option to amortize pollution control facilities over a 5-year period (IRS, 1988). Under this IRS
provision, 75 percent of the investment could be rapidly amortized in a 5-year period using a
straight line method. The 75-percent figure is based on the ratio of the allowable lifetime (15
years) to the estimated  usable life (20 years) as specified in IRS Section 169, Subsection (f).
Although the tax provision enables the facility to expense the investment over a shorter time
period, the advantage is substantially reduced because only 75 percent of the capital investment
can be recovered. Table A-5 illustrates this  tax provision using hypothetical costs. The present
value of the tax shield from depreciation increases only slightly, thereby decreasing the present
value of annualized costs from  $101,207 (see Table A-2) to $100,070 (see Table A-5).  Because
the benefit of the provision is so slight and facilities might not be able to get the required
certification to take advantage of it, this provision was not included in the cost annualization
model.  Its exclusion results in a more conservative  estimate of compliance costs.
A.6    REFERENCES

Fortune Magazine, 1991. Fortune Forcast. June 3. pp. 22-23.
Commerce Clearinghouse, Inc. 1991. U.S. Master Tax Guide.  Chicago, 1990.
                                           A-9

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-------
                     APPENDIX B

RESULTS OF SENSITIVITY ANALYSIS USING NO SALVAGE VALUE
           IN COMPUTING FACILITY CLOSURES
                        B-l

-------
                                     APPENDIX B
     RESULTS OF SENSITIVITY ANALYSIS USING NO SALVAGE VALUE
                     IN COMPUTING FACILITY CLOSURES
       In Section Five, the EIA presented an analysis of facility closures using the assumption
that salvage value plays a role in the decision for a multifacility firm to close and liquidate a
marginally profitable or unprofitable facility.  Using salvage value in a closure model might not
accurately reflect closure decisions. First, salvage value is difficult to compute accurately.
Second, under some circumstances (for instance if the facility acts as a captive to the owner firm,
transferring goods to the owner firm rather than selling goods at market prices)  the salvage value
of a single facility might be irrelevant to closure decisions.  To  determine whether using salvage
value makes any difference in the  outcome of the facility closure analysis, this appendix presents
a sensitivity analysis, where salvage value is assumed to be $0 for all facilities.

       Table B-l presents the results of this alternative analysis in the baseline.  As the table
shows,  only 18 facilities, or 6 percent of all facilities in the  analysis are expected  to close under a
zero salvage value assumption. In contrast, in Section Five, 38 facilities,  or 13 percent of all
facilities were estimated to close in the baseline.

       In the postcompliance analysis, as Tables B-2 and B-3 show, there is no change  from the
results  shown for A/C and B/D direct dischargers in Section Five. For the A/C indirects,
however, where no facilities closed under any of the regulatory options in the Section Five
analysis, one, one, two, and four facilities are expected to close under Options #1, #2, #3, and
#4, respectively, when zero salvage value is assumed (see Table B-4). Four B/D indirects also
are estimated to close under PSES-B/D#3 with a zero salvage value assumed, vs. only one in the
Section Five analysis.  Under the selected regulatory options, however, only one  facility closes
when a zero salvage value  is  assumed (see Table B-5). This difference in results from the
original analysis is so slight that EPA chose to continue using the standard  analysis used in
previous effluent guidelines EIAs rather than to assume  that salvage value plays  no role in the
decision to  close a facility.
                                          B-3

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                  APPENDIX C




ANALYSIS OF THE ALTERNATIVE REGULATORY SCENARIO
                    C-l

-------
                               APPENDIX C
       ANALYSIS OF THE ALTERNATIVE REGULATORY SCENARIO
      Tables C-l through C-8 present the results of analyses of the alternative regulatory
scenario (steam stripping/distillation) discussed in the main body of this report.
                                   C-3

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-------
                                      TABLE C-2

                           POSTCOMPLIANCE ANALYSIS 1 *
                       ALTERNATIVE REGULATORY OPTIONS

Firms with A/C Direct Facilities
Finns with B/D Direct Facilities
Finns with A/C Indirect Facilities
Finns with B/D Indirect Facilities
Total
Number
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* This scenario analyzes impacts from regulating A/C Direct facilities under options BAT-A/C#2
and BPT-A/C#2, B/D Direct facilities under options BAT-B/D#1 and BPT-B/D#2, A/C Indirect
facilities under option PSES-A/C#1, and B/D Indirect facilities under option PSES-B/D#1.
** Out of all firms in the postcompliance analysis (133 firms).
+ Number of firms for All Firms might be less than the total firms by subcategory because some
firms have more than one type of facility.  Total number of All Firms includes firms that have
nondischarging facilities

Note: Analysis excludes three firms because of lack of financial data.

Source: ERG estimates.
                                           C-5

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-------
                                        TABLE C-5

INCREMENTAL RECORDKEEPING AND REPORTING COSTS FOR ALTERNATIVE OPTIONS
Employment
Size of Firm
0-18
19-99
100 - 499
500 - 750
>750
# Firms with
Nonzero
Compliance
Costs
9
26
47
17
40
Total
Monitoring
Costs
$105,215
$984,005
$1,623,545
$844,635
$5,478,385
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1%
11%
18%
9%
61%
Total Pretax
Compliance
Costs*
$726,763
$11,281,919
$17,725,628
$15,549,877
$138,878,766
Monitoring Costs
as % of
Compliance Costs**
1.2%
7.8%
9.3%
6.8%
6.6%

All Finns <= 750
All Firms
99
139
$3,557,400
$9,035,785
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100%
$45,284,187
$184,162,953
8.6%
7.8%
* Pretax compliance costs are amraalized at 11.4%.
** Percentage calculated as the median of monitoring costs divided by compliance costs for each firm in
the group rather than average monitoring costs divided by average compliance costs. Analysis does
not include firms with zero compliance costs.

Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report.

Source: ERG estimates based on Radian Corp. estimates of capital and operating costs for pollution control
equipment (including operating costs).
                                             C-8

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-------
                        TABLE C-7

PRESENT VALUE OF COMPLIANCE COSTS AS A PERCENTAGE
  OF PRESENT VALUE OF POSTCOMPLIANCE NET INCOME
                FOR ALTERNATIVE OPTIONS
Employment
Size of Finn
0-18
19-99
100 - 499
500 - 750
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Median
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Costs (PV)
$0
$817,485
$3,324
$453,882
$1,893,578
Median
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Net Income (PV)
$427,787
$5,675,197
$58,170,339
$432,324,319
$1,430,472,878
Compliance
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of Net Income*
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11.12%
0.02%
0.05%
0.47%

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All Finns
$54,327
$597,190
$45,984,357
$102,698,480
0.09%
0.14%
* Median for each group is based on percentage calculated for each firm in
the group rather than median compliance costs divided by median
postcompliance net income.

Note:
1. Analysis excludes three firms because of lack of financial data.
2. Analysis excludes all firms with certified facilities.
3. Analysis includes only those firms that pass both the baseline and
postcompliance analyses.

Source: ERG estimates.
                               C-10

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